Auditing & Assurance Services 8th Edition by Louwers, Bagley, Blay, Strawser

SOLUTION MANUAL FOR Auditing & Assurance Services 8th Edition by Timothy Louwers, Allen Blay, David Sinason, Jerry Strawser, Jay Thibodeau Chapter 01 - Auditing and Assurance Services CHAPTER 01 Auditing and Assurance Services LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company.

1, 2, 3

29, 31, 38

65*

Define and contrast financial statement auditing, attestation, and assurance services.

4, 5, 6, 7, 8

23, 25, 28, 44, 50

60, 65*

Describe and define the assertions that management makes about the recognition, measurement, presentation, and disclosure of the financial statements and explain why auditors use them as a focal point of the audit.

9, 10, 11

36, 39, 40, 41, 45, 46, 47, 48, 49, 52, 53, 54, 55, 57, 58, 59

62, 63, 67

Define professional skepticism and explain its key characteristics.

24, 37

Describe the organization of public accounting firms and identify the various services that they offer.

13, 14

30, 42, 56

64*

Describe the audits and auditors in governmental, internal, and operational auditing.

15, 16, 17, 18

26, 27, 32, 34, 35

64*, 66

List and explain the requirements for becoming a certified public accountant (CPA) and other certifications available to an accounting professional.

19, 20, 21, 22

33, 43, 51

68, 69

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 1.1

Business risk is the risk that an entity will fail to meet its business objectives. When assessing business risk, a professional must consider all possible threats to an entity‘s goals and objectives. Some illustrative examples include the risk that: 1) its existing customers will start buying products or services from its primary competitors; 2) its product lines will become obsolete; 3) its taxes will increase; 4) key government contracts will be lost; 5) key employees will leave the entity; and many other examples exist.

1.2

To help minimize business risk and take advantage of other opportunities presented in today‘s competitive business environment, decision makers such as chief executive officers (CEOs) demand timely, relevant, and reliable information. There are at least four environmental conditions that increase demand for reliable information. First, complexity which implies that events and transactions in today‘s global business environment can be complicated. Most investors do not have the level of expertise needed to properly account for complex transactions. Second is remoteness which implies that decision makers are often separated from current and potential business relationships due to distance and time. For example, investors may not be able to visit distant locations to check up on their investments. Third is time-sensitivity which implies that in today‘s economic environment, investors and other users of financial statements need to make decisions more rapidly than ever before. As a result, the ability to promptly obtain high-quality information is essential. Fourth is a consequence which implies that decisions may very well involve significant investments. As a result, the consequences can be severe if information cannot be obtained

1.3

Of all the different risks discussed in the chapter up to this point, information risk is the one that is most likely to create the demand for independent and objective assurance services is information risk or the probability that the information circulated by an entity will be false or misleading. Because the primary source of information for investors and creditors is the company itself, an incentive exists for that company‘s management to make their business or service appear to be better than it actually may be, to put their best foot forward. As a result, preparers and issuers of financial information (directors, managers, accountants, and other people employed in a business) might benefit by giving false, misleading, or overly optimistic information. This potential conflict of interest between information providers and users which provides the underlying basis for the demand for reliable information.

1.4

According to the American Accounting Association, ―Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users.‖ In effect, auditors add reliability to the information that is provided to interested users. Of course, this definition is focused on an external reporting context. Students may also discuss how governmental and internal auditors operate as well. In response to ―What do auditors do?‖ students can respond by stating that auditors (1) obtain and evaluate evidence about assertions made by management about economic actions and events, (2) ascertain the degree of correspondence between the assertions and the appropriate reporting framework, and (3) issue an audit report (opinion). Students can also respond more generally by stating that auditors essentially lend credibility to the financial statements presented by management.

1.5

An attestation engagement is ―an engagement in which a practitioner is engaged to issue or does issue a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party‖(SSAE 10, AT 101.01). To attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. The attest function is a term often applied to the activities of independent CPAs when acting as auditors of financial statements.

1.6

An assurance services engagement is any assignment that improves the quality of information, or its context, for decision makers. Because information (e.g., financial statements) are prepared by managers of an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical that the information truly is objective, free from bias, fully informative, and free from material error, intentional or inadvertent. The services of an independent auditor helps resolve those doubts because the auditor‘s success depends upon his or her independent, objective, and competent assessment of the 1-3 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

information (e.g., the conformity of the financial statements with the appropriate reporting framework). The independent auditor‘s role is to lend credibility to the information; hence, the outsider will likely seek his or her independent opinion about the financial statements. 1.7

An assurance service engagement is one that improves the quality of information, or its context, for decision makers. Thus, an attestation service engagement is one type of an assurance service. Another way of thinking about the issue is to remember that the financial statement audit engagement is one type of an attestation service. Please see exhibit 1.3 in the text which depicts the relationship among assurance, attestation, and auditing engagements.

1.8

The four major elements of the broad definition of assurance services are Independence. CPAs want to preserve their reputation and competitive advantage by always preserving integrity and objectivity when performing assurance services. Professional services. Virtually all work performed by CPAs is defined as ―professional services‖ as long as it involves some element of judgment based on education and experience. Improving the quality of information or its context. The emphasis is on ―information,‖ CPAs‘ traditional area of expertise. CPAs can enhance quality by assuring users about the reliability and relevance of information, and these two features are closely related to the familiar credibility-lending products of attestation and audit services. ―Context‖ is relevance in a different light. For assurance services, improving the context of information refers to improving its usefulness when targeted to particular decision makers in the surroundings of particular decision problems. For decision makers. As the ―consumers‖ of assurance services, decision makers are the beneficiaries of the assurance services. Decision makers may or may not be the ―client‖ that pays the fee and may or may not be one of the parties to an assertion or other information, but they personify the consumer focus of new and different professional work.

1.9

Financial accounting refers to the process of recording, classifying, summarizing and reporting about a company‘s assets, liabilities, capital, revenues, and expenses in the financial statements in accordance with the applicable financial reporting framework (e.g., GAAP). In so doing, the management team is making a number of assertions about the financial statements. The financial accounting process is the responsibility of the management team. Financial statement auditing refers to the process whereby professional auditors gather evidence related to the assertions that management makes in the financial statements, evaluates the evidence and concludes on the fairness of the financial statements in a report. They differ because accountants produce the financial statements in accordance with the applicable financial reporting framework. After this is complete, financial statement auditors then perform procedures to ascertain whether the financial statements have been prepared in accordance with the applicable financial reporting framework.

1.10

The three major classifications of ASB assertions with several assertions in each classification are: Transaction Assertions (i.e. Income Statement) Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets, liabilities, sales, and expenses actually occurred. Key questions include ―Did the recorded sales transactions really occur?‖ Completeness and cutoff assertion: The objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly belong in the preceding or following accounting periods are excluded. Completeness also refers to proper inclusion in financial statements of all 1-4 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

assets, liabilities, revenue, expense, and related disclosures. Key questions related to completeness include ―Are the financial statements (including footnotes) complete?‖ and ―Were all the transactions recorded in the right period?‖ Accuracy assertion: The objective is to establish with evidence that transactions have been recorded at the correct amount. Key questions include ―Were the expenses recorded at the proper dollar amount?‖ Classification assertion: The objective is to establish with evidence that transactions were posted to the correct accounts. Key questions include ―Was this expense recorded in the appropriate account?‖ Balance Assertions (i.e., Balance Sheet) Existence assertion: The objective is to establish with evidence that the balance represents assets, liabilities, sales, and expenses that are real and in existence at the balance sheet date. Key questions include ―Does this number truly represent assets that existed at the balance sheet date?‖ Rights and obligations assertion: The objectives related to rights and obligations are to establish with evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed. Key questions related to this assertion include ―Does the company really own the assets? And ―Are related legal responsibilities identified?‖ Completeness assertion: The objective is to establish with evidence that all balances of the period are in the financial statements. Key questions related to completeness include ―Are the financial statements (including footnotes) complete?‖ Valuation assertion: The objective is to establish with evidence that balances have been valued correctly. Key questions include ―Are the accounts valued correctly?‖ and ―Are expenses allocated to the period(s) benefited?‖ Presentation and Disclosure Assertions (i.e., Footnotes) Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets, liabilities, sales and expenses actually occurred. Key questions include ―are we properly presenting and disclosing transactions that occurred during this period?‖ Rights and obligations assertion: The objectives related to establishing with evidence the proper presentation of assets, liabilities, revenues and expenses to which the company has a legal right or a legal obligation Key questions related to this assertion include: ―Has the company properly presented the assets in its possession? And, ―Are related legal responsibilities identified and properly disclosed?‖ Completeness assertion: The objective is to establish with evidence that all balances of the period are presented and/or disclosed in the financial statements. Key questions related to completeness include: ―Are the financial statements (including footnotes) complete?‖ Accuracy and valuation assertion: The objectives are to establish with evidence that balances presented and disclosed in the financial statements have been recorded accurately and have been valued correctly. Key questions include ―Are the accounts valued correctly?‖ and ―Are expenses allocated to the period(s) benefited?‖ Classification and understandability assertion: The objective is to establish with evidence that presentation and disclosures are properly classified on the financial statements and that financial statements including footnotes are understandable to the financial statement users. Key questions relate to ―Is this account properly presented in the correct financial statement category‖ And, ―are the footnote disclosures presented to promote an understanding of the nature of the account?‖

1.11

The ASB set of management financial statement assertions are important to auditors because they are used when assessing risks by determining the different types of misstatements that could occur for each assertion. Next, auditors use the assertions to develop audit procedures that are appropriate to mitigate the risk of material misstatement for each assertion. In essence, the key questions that must be answered about each of the relevant assertions become the focal points for audit procedures. Audit procedures are the means to answer the key questions posed by management‘s financial statement assertions. In fact, the procedures are completed to provide the evidence necessary to persuade the auditor that there is no material misstatement related to each of the relevant assertions identified for an engagement. The ASB assertions differ from the PCAOB assertions in that they provide greater detail and clarity for auditors to conceptualize the type of misstatements that may exist in the financial statements. Thus, the PCAOB assertions are more general than the ASB assertions. Importantly, the PCAOB recognizes that their assertions are more general and do allow auditors to use the more granular and specific ASB assertions when completing the audit. As a result, largely all of the firms auditing public companies with international operations feature the ASB assertions to guide their auditing processes. Importantly, a student of auditing will note that the ASB assertions are in direct alignment with the PCAOB assertions. This is illustrated in the text in Exhibit 1.4

1.12

Holding a belief that a potential conflict of interest always exists between the auditor and the management team causes auditors to always be skeptical when completing the audit. Indeed, even though the vast majority of audits do not contain fraud, auditors have no choice but to consider the possibility of fraud on every audit. Stated simply, errors and financial reporting frauds have happened in the past, and users of financial statements and audit reports expect auditors to detect material misstatements if they exist. Indeed, auditing firms have long recognized the importance of exercising professional skepticism when making professional judgments. As a student of auditing, you can definitely expect to encounter difficult economic transactions as an auditor. When a difficult transaction is encountered, auditors must take the time to fully understand the economic substance of that transaction and then critically evaluate, with skepticism, the evidence provided by the client to justify its accounting treatment. There are no shortcuts allowed. Rather, auditors must always hold a belief that a potential conflict of interest exist between the auditor and management and they must be unbiased and objective when making their professional judgments.

1.13

Generally speaking, assurance services involve the lending of credibility to information, whether financial or nonfinancial. CPAs have assured vote counts (e.g., Baseball Hall of Fame), dollar amounts of prizes that sweepstakes have claimed to award, accuracy of advertisements, investment performance statistics, and characteristics claimed for computer software programs. Some specific examples of assurance service engagements performed on nonfinancial information include 

eXtensible Business Reporting Language (XBRL) reporting.



Enterprise risk management assessment.



Information risk assessment and assurance.



Third-party reimbursement maximization.



Rental property operations review.



Customer satisfaction surveys.



Evaluation of investment management policies.



Fraud and illegal acts prevention and deterrence.



Internal audit outsourcing.

1.14

There are three major areas of public accounting services   

Financial Statement Audit and other types of Assurance services. Tax services. Consulting and Advisory services.

1.15

Operational auditing is the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. The AICPA views operational auditing as a type of consulting or advisory service offered by public accounting firms.

1.16

The GAGAS issued by the GAO is very clear on this point. Specifically, the elements of expanded-scope auditing include (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program results audits.

1.17

Compliance auditing involves a study of an organization‘s policies, procedures, and, ultimately, its performance in following applicable laws, rules, and regulations. An example would be a school district‘s policies and procedures related to a meal program for its students. In these types of situations, there would be a demand for a compliance audit which would be designed to insure that the school district complies with the stated policies and procedures of the program.

1.18

Other kinds of auditors include Internal Revenue Service auditors who are required to audit the taxable income and deductions taken by taxpayers in tax returns and determine their correspondence with the standards found in the Internal Revenue Code. They also might have to audit for fraud and tax evasion. Other examples include state and federal bank examiners who are responsible for auditing banks, savings and loan associations, and other financial institutions for evidence of solvency and compliance with banking and other related laws and regulations.

1.19

The purpose of the continuing education requirement is to ensure that CPAs in practice maintain their expertise at a sufficiently high level in light of evolving business conditions and new regulations. For CPAs in public practice, 120 hours of continuing education is required every three years with no less than 20 hours in any one year. For CPAs not in public practice, the general requirement is 120 or fewer (90 in some states) every three years.

1.20

Not everything can be learned in the classroom, and some on-the-job experience is helpful before a person is able to be held out to the public as a licensed professional. Also, the experience requirement tends to ―weed out‖ those individuals who are just looking to become certified without ever being involved in actual accounting work.

1.21

State boards administer the state accountancy laws and are responsible for ensuring that candidates have passed the CPA examination and satisfied the state requirements for education and experience before being awarded a CPA certificate. At the same time, new CPAs must pay a fee to obtain a state license to practice. Thereafter, state boards of accountancy regulate the behavior of CPAs under their jurisdiction (enforcing state rules of conduct) and supervise the continuing education requirements. As a result, the state boards play an important role in the CPA certification and licensure process.

1.22

After becoming a CPA licensed in one state, a person can obtain a CPA certificate and license in another state. The process is known as reciprocity. CPAs can file the proper application with another state board of accountancy, meet the state‘s requirements, and obtain another CPA certificate. Many CPAs hold certificates and licenses in several states. From a global perspective, individuals must be licensed in each country. Similar to CPAs in the United States, chartered accountants (CAs) practice in Australia, Canada, Great Britain, and India.

SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS 1.23

1.24

1.25

1.26

Incorrect

Correct

Incorrect

c. d.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

This is an attestation to the prize promoter‘s claims. Because attestation and audit engagements are subsets of assurance engagements, this is an example of an assurance engagement. However, each response is an example of an assurance engagement; thus, the answer is (e). This is an audit engagement to give an opinion on financial statements. Because attestation and audit engagements are subsets of assurance engagements, this is an example of an assurance engagement. However, each response is an example of an assurance engagement; thus, the answer is (e). This is an assurance engagement on a newspaper‘s circulation data. Because attestation and audit engagements are subsets of assurance engagements, all are assurance engagements. Thus, the answer is (e). This is an assurance engagement on the performance of golf balls. Because attestation and audit engagements are subsets of assurance engagements, all are assurance engagements. Thus, the answer is (e). Because attestation and audit engagements are subsets of assurance engagements, all of the responses are examples of assurance engagements. The management team is generally trying to put its ―best foot forward‖ when reporting their financial statement information. The auditor must make sure that the management team does not violate the accounting rules when doing so. IN essence, this statement characterizes why professional skepticism is required to be exercised by auditors. ―Exclusively in the capacity of an auditor‖ is not an idea that relates to an attitude of professional skepticism. Professional obligations are not related to an attitude of professional skepticism. While it is true that financial statement and financial data are verifiable, this does not related to the reasons why an auditor needs to begin an audit with an attitude of professional skepticism. While work on a forecast would potentially be covered by the attestation standards, the auditors must provide assurance about some type of management assertion in an attestation engagement. This is the basic definition of an attestation service, as articulated in the book and the professional standards. Since there is no assurance about any management assertion when preparing a tax return with information that has not been reviewed or audited, this type of tax work is not considered an attestation service. Since there is no assurance about any management assertion when giving expert testimony about particular facts in an income tax case, this type of work is not considered an attestation service. The objective of environmental auditing is to help achieve and maintain compliance with environmental laws and regulations and to help identify and correct unregulated environmental hazards. This answer is therefore incorrect. The objective of financial auditing is to obtain assurance on the conformity of financial statements with generally accepted accounting principles. This answer is therefore incorrect. The objective of compliance auditing is the entity‘s compliance with laws and regulations. This answer is therefore incorrect. Operational auditing refers to the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies.

1.27

1.28

1.29

1.30

Incorrect

Correct

c. d.

Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

This is not the primary objective of an operational audit. However, while completing an operational audit, a professionally skeptical auditor should still be concerned about compliance with financial accounting standards. This statement exactly characterizes the goal of an operational audit. In addition, the statement is part of the basic definition of operational auditing. An operational audit does not focus on the financial statements of an entity. While analytical tools and skills may be used during an operational audit, they are also a very important aspect of financial auditing. According to the AICPA definition found in AU 200 (paragraph 11) and in your book, ―the purpose of an audit is to enhance the degree of confidence that intended users can place in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. As a result, this is the correct response. The AICPA definition is not limited to the FASB for the appropriate reporting framework that is used as the benchmark when completing an audit. The definition is general enough to include other financial reporting frameworks as well, such as IFRS. The AICPA definition does not focus on the SEC as an appropriate reporting framework to be used as a benchmark when completing an audit. The definition is focused on the ―applicable‖ financial reporting framework, such as GAAP or IFRS. The reference to the SEC is wrong. This phrase is not referenced in the AICPA definition found in the auditing standards. This phrase is found in the AAA definition of the audit found in this book. While complexity is an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. While remoteness is an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. While the consequences of making a bad decision are an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. The potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. Consider for example a company that was desperate for cash in order to survive. Would it be possible that the management team would present unreliable financial statements to the bank in order to get a desperation loan? Because of this possibility, a financial statement audit is needed to add credibility to the financial statements. According to Section 201 of the Sarbanes-Oxley Act, bookkeeping services are prohibited. According to Section 201 of the Sarbanes-Oxley Act, internal audit services are prohibited. According to Section 201 of the Sarbanes-Oxley Act, valuation services are prohibited. Sarbanes-Oxley prohibits the provision of all of the services listed in answers a, b, and c; therefore, d (all of the above) is the best response.

1.31

1.32

1.33

1.34

1.35

a. b.

Incorrect Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

a. Incorrect b. (&d) Correct c. Incorrect d. (&b) Correct

1.36

Incorrect

Correct

Financial statement auditors do not reduce business risk. After completing a financial statement audit, information risk has been reduced for investors. Complexity creates demand for accounting services but is not an objective of the financial statement audit. Auditors do not directly control the timeliness of financial statements. Management must first provide the information to be audited. A financial statement opinion is the objective of a financial statement audit, not a compliance audit. A basis for a report on internal control is the objective of an internal control audit under Section 404 of the Sarbanes-Oxley Act, not a compliance audit. A study of effective and efficient resources is the objective of an operational audit, not a compliance audit. A compliance audit refers to procedures that are designed to ascertain that the company‘s personnel are following laws, rules, regulations, and policies. While successful completion of the Uniform CPA is necessary to be licensed as a CPA, a candidate also requires the proper experience and proper education. Thus, letter (d.) is correct. While proper experience is necessary to be licensed as a CPA, a candidate also requires the successful completion of the Uniform CPA and proper education. Thus, letter (d.) is correct. While proper education is necessary to be licensed as a CPA, a candidate also requires the successful completion of the Uniform CPA and proper experience. Thus, letter (d.) is correct. A candidate requires the successful completion of the Uniform CPA, proper experience and proper education to be licensed as a CPA. The GIAA is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. The CIA is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. The SEC is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. The mission of the U.S. Government Accountability Office is to ensure that public officials are using public funds efficiently, effectively, and economically. A financial audit is typically not included as part of a performance audit. The two categories of performance audits are economy and efficiency audits and program audits. A compliance audit is typically not included as part of a performance audit. The two categories of performance audits are economy and efficiency audits and program audits. A review of credit ratings of customers would not provide evidence about the completeness of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. A review of credit ratings of customers would not provide evidence about the existence of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. A review of credit ratings of customers‘ gives indirect evidence of the collectability of accounts receivable. Because GAAP requires the accounts

1.37

1.38

1.39

1.40

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. A review of credit ratings of customers would not provide evidence about the rights of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. A review of credit ratings of customers would not provide evidence about the occurrence of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. Rhonda‘s representations are not sufficient evidence to support assertions made in the financial statements. Despite Rhonda‘s representations, Jones must gather additional evidence to corroborate Rhonda‘s assertions. Rhonda‘s representations are a form of evidence (albeit weak) that should neither be disregarded nor blindly regarded without professional skepticism. Rhonda‘s assertions are nice. However, to be considered as sufficient to conclude that all expenses have been recorded, they will need corroboration with documentary evidence. Thus, this is the correct response. Although there is a high level of risk associated with client acceptance, this phrase was created by the authors. By definition, information risk is the probability that the information circulated by a company will be false or misleading. Moral hazard is the risk that the existence of a contract will change the behavior of one or both parties to the contract. Business risk is the probability an entity will fail to meet its strategic objectives. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. This is not an existence test. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. This is not a test of valuation. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. This is not a test of rights and obligations. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. This is not an occurrence test. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. This is not a completeness test. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the

1.41

Incorrect

Correct

Incorrect

Correct

Incorrect

company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not an existence test. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not a test of valuation. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not an occurrence test. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not a test of completeness. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. This is a test of existence. This test is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. This is not a test of valuation. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP.

1.42

1.43

1.44

Incorrect

Correct

Incorrect

Correct

Incorrect

This is not a test of rights and obligations. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. This is not a test of occurrence. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. Under Sarbanes-Oxley, public accounting firms are prevented from acting in a managerial decision-making role for an audit client. Under Sarbanes-Oxley, public accounting firms are prevented from auditing the firm‘s own work on an audit client. Under Sarbanes-Oxley, public accounting firms may only provide tax consulting services to an audit client with the audit committee‘s approval. Sarbanes-Oxley prevents public accounting firms from serving an audit client in any of the preceding listed roles. As a result, each of the responses a, b, and c is incorrect and letter d is the correct response. Substantial equivalency does not refer to the financial statement auditing process. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. Substantial equivalency does not refer to consulting services. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. Substantial equivalency does not refer to other professional organizations. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. Substantial equivalency relates to the practice of public accountancy in states other than a CPA‘s state of licensure. Under the concept of substantial equivalency, as long as the licensing (home) state requires (1) 150 hours of education, (2) successful completion of the CPA exam, and (3) one year of experience, a CPA can practice (either in person or electronically) in another substantial equivalency state without having to obtain a license in that state. Auditing is a subset of attestation engagements that focuses on the certification of financial statements. The subject matter is the set of financial statements from management and the criteria is GAAP in the United States. That is not true. Auditing is one example of an attest engagement. The level of assurance provided is not lower for an attestation engagement. That is not true. The auditor is not allowed to provide management support for its audit clients. Rather, consulting engagements can focus on providing clients with advice and decision support. The definition provided is the one for assurance engagements, which is quite broad and includes all engagements that are designed to improve the quality of information, or its context, for decision makers.

1.45

1.46

1.47

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. Although rights and obligations is an important assertion, it is not the most relevant assertion for the cash balance. Since management is more likely to overstate assets, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. Although valuation is an important assertion, it is not the most relevant assertion for the cash balance. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. If however, there was a foreign currency translation adjustment, valuation of cash would also be relevant. Although occurrence is an important assertion, it is not the most relevant assertion for any balance sheet account. Rather, the occurrence assertion is more closely related to income statement accounts because the question that needs to be answered with evidence is whether the transaction really did occur in accordance with GAAP. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. This evidence would provide evidence about management‘s assertion about rights and obligations and perhaps existence. However, this evidence would not help to value the investment in accordance with GAAP. While this evidence would potentially be helpful to value an investment in another company, it is not the best answer. If a quote was available from an independent source, this would be a better form of evidence for valuation. This evidence would provide evidence about management‘s assertion about existence and perhaps rights and obligations. However, this evidence would not help to value the investment in accordance with GAAP. Always remember that management is more likely to overstate assets. As a result, when auditing an asset balance like investments, a relevant assertion is likely to be valuation. In this situation, to answer the question of what the investment should be valued at in the balance sheet, an auditor would first seek to obtain a market quotation from an independent source like the Wall Street Journal. This test is not related to presentation and disclosure. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. This test is not related to rights and obligations. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. This test is not related to existence. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded.

1.48

1.49

1.50

1.51

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

This test is designed to test the completeness assertion for the inventory account. It does not provide any evidence related to the rights and obligations assertion. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that the inventory reported as assets really is owned by the company. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This test is designed to test the completeness assertion for sales revenue. It does not provide evidence related to the rights and obligations assertion for inventory. This test is designed to test the presentation and disclosure assertion for inventory purchase commitments. It does not provide evidence related to the rights and obligations assertion for inventory. Management is far more likely to understate liabilities than to overstate them. As a result, when auditing the accrued liabilities account, existence or occurrence is not as likely to be violated. Rather, the most relevant assertion is likely to be completeness. Management is more likely to understate liabilities. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. Management is far more likely to understate liabilities. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. Presentation and disclosure may be relevant. However, it is not as likely to contain a material misstatement as completeness. Management is far more likely to understate liabilities than to overstate them. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. Valuation may be relevant. However, it is not as likely to contain a material misstatement as completeness. This is not correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP. Also, a consulting engagement is one where the professional provides advice and decision support. This is not correct as a consulting engagement is one where the professional provides advice and decision support. Also, an assurance engagement can include many more types of information than just the financial statements. This is not correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP. Also, a consulting engagement is one where the professional provides advice and decision support. This is correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP and an attestation engagement can include a financial statement audit. In addition, An assurance engagement can apply to all types of information and a consulting engagement is one where the professional provides advice and decision support. Credibility is a reason to become certified. Because all three responses are reasons, (d) is correct. Advancement and promotion are reasons to become certified. Because all three responses are reasons, (d) is correct. Monetary reward is a reason to become certified. Because all three responses are reasons, (d) is correct. Credibility, advancement, and monetary rewards are all reasons to become certified.

1.52

1.53

1.54

Incorrect

Correct

Incorrect

Although existence or occurrence is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. Although completeness is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. Although valuation is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. Management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. Although completeness is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. Although presentation and disclosure is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. Although rights and obligations is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. Although rights and obligations is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing.

1.55

1.56

Correct

Incorrect

Correct

Incorrect

Correct

Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. Although existence is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. Although valuation is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. Although rights and obligations is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. Although existence is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. Although valuation is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. Since there is no assurance about any management assertion provided when completing an engagement to implement an ERP system, this is not considered an attestation service. This is a consulting service. Since there is no assurance about any management assertion provided when completing an engagement to develop a more efficient payroll process, this is not considered an attestation service. This is a consulting service. This is an attestation service. In order to assess the effectiveness of an internal control system, the assurance provider would have to attest to management‘s assertion that the internal control was effective in accordance with the COSO framework, as this is the most common way of expressing the effectiveness of

1.57

1.58

Incorrect

Correct

Incorrect

an internal control system. As a result, this is the definition of an attestation service, as articulated in the book and the professional standards. Since there is no assurance about any management assertion when assisting the client in an IRS audit, this type of work is not considered an attestation service. Although rights and obligations is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. Valuation and allocation is the PCAOB assertion that is most likely to be tested. In general, management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. Although presentation and disclosure is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. Although completion is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. Although existence is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation. Although completeness is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation. Although presentation and disclosure is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation.

1.59

Correct

Valuation is the correct answer. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation.

Correct

Incorrect

Rights and obligations is the correct answer. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. Although completeness is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. Although existence or occurrence is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. Although valuation or allocation is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question.

SOLUTIONS FOR EXERCISES AND PROBLEMS 1.60

Audit, Attestation, and Assurance Services Students may encounter some difficulty with this matching question because the Special Committee on Assurance Services (SCAS) listed many things that heretofore have been considered ―attestation services‖ (long before assurance services were invented). As a result, we believe that this question is a good vehicle for discussing the considerable overlap that exists between attestation and assurance services. 

Real estate demand studies: Assurance service



Ballot for awards show: Assurance service



Utility rates applications: Assurance service



Newspaper circulation audits: Assurance service

1.61



Third-party reimbursement maximization: Assurance service



Annual financial report to stockholders: Audit service



Rental property operations review: Assurance service



Examination of financial forecasts and projections: Attestation service



Customer satisfaction surveys: Assurance service



Compliance with contractual requirements: Attestation service



Benchmarking/best practices: Assurance service



Evaluation of investment management policies: Assurance service



Information systems security reviews: Assurance service



Productivity statistics: Assurance service



Internal audit strategic review: Assurance service



Financial statements submitted to a bank loan officer: Audit service

Controller as Auditor When Hughes Corporation hired the CPA, she or he can no longer be considered independent with respect to the annual audit and, as a result, can no longer perform an independent audit of the financial statements. It is true that the in-house CPA can perform all procedural analyses that would be required of an independent audit; however, it is extremely unlikely that the CPA could inspire the confidence of users of financial statements outside the company. Because she or he is no longer independent of the company, the CPA cannot modify the perception of potential conflict of interest that creates demand for the independent audit. As a matter of ethics rules, this CPA would be prohibited from signing the standard unqualified attest opinion. Moreover, if Hughes were a public company, under Sarbanes-Oxley, it would be restricted from hiring one of its auditors into a senior accounting position for a full year under Section 206 of the law.

1.62

Management Assertions

PCAOB Assertion

Corresponding ASB assertion

Nature of assertion

Existence or Occurrence

Existence

Balance

Occurrence

Transactions Disclosures

Rights and Obligations

Balances Disclosures

Completeness

Transactions Balances Disclosures

Valuation and Allocation

Cutoff

Transactions

Accuracy

Transactions Disclosures

Valuation

Balances Disclosures

Presentation and Disclosure

Classification

Transactions Disclosures

Understandability 1.63

Disclosures

Management Assertions

Existence or Occurrence - Assertions about existence or occurrence address whether assets or liabilities of the entity exist at a given date and whether recorded transactions have occurred during a given period. For example, management asserts that Accounts Receivable on the balance sheet represent valid amounts owed to the company that were likely provided the in exchange for goods or services from the company. Completeness - Assertions about completeness address whether all transactions and accounts that should be presented in the financial statements are so included. For example, management asserts that all amounts that should be recorded and included in the financial statements as accounts receivable actually have been recorded. Valuation or Allocation - Assertions about valuation or allocation address whether asset, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts. For example, management asserts that Accounts Receivable are stated at net realizable value. Rights and Obligations - Assertions about rights and obligations address whether assets are the rights of the entity and liabilities are the obligations of the entity at a given date. For example, management asserts that the Accounts Receivable on the balance sheet really are owned by the company. As a result, they have not factored (i.e., sold) any of the balances that are listed on the balance sheet.

Presentation and Disclosure - Assertions about presentation and disclosure address whether particular components of the financial statements are properly classified, described, and disclosed. For example, management asserts that the presentation of accounts receivable and the related allowance for doubtful accounts have been presented and are disclosed in accordance with GAAP. 1.64

Operational Auditing One possibility is someone from the management advisory services department of a CPA firm. The major advantage may be total objectivity. The CPA firm has no stake in making a report reflect favorably or unfavorably on Smalltek (provided there are no prior relations of the CPA firm with Bigdeal managers that may suggest a bias or with Smalltek). The possible disadvantage is that the CPA firm may not possess the required expertise in Smalltek‘s industry or type of business. Another possibility is the Bigdeal internal audit department. The major advantage may be that the internal audit department has a thorough appreciation of Bigdeal‘s managerial effectiveness and efficiency standards and a long-standing familiarity with Bigdeal‘s business. The possible disadvantage could be that the internal auditors may not be independent or objective enough from internal management pressures for making or breaking the deal for reasons other than Smalltek‘s efficiency and effectiveness. Another possibility is a non-CPA management consulting firm. The major advantage of objectivity would be similar to the CPA firm, and such firms often have experts in manufacturing, sales, and research and development management. The major disadvantage could be a lack of appreciation and familiarity with Bigdeal‘s management standards (as possessed by the Bigdeal internal auditors). In addition, such firms are typically very expensive.

1.65

Auditor as Guarantor. Loot Starkin appears to be uninformed on the following key points:

The auditors did not prepare the Dodge Corporation financial statement.

Inform your neighbor that Dodge management is primarily responsible for preparing the financial statements and deciding upon the appropriate accounting principles.

An unqualified opinion does not mean that an investment is safe. Rather, it merely means that the financial statements are free of material misstatement.

Tell your neighbor that the financial statements are a historical record of the business‘ performance. The value of Loot‘s investment depends on future events, including the many factors that affect market prices. Thus, the financial statements are just one piece of information that should be analyzed. Tell Loot that the unqualified opinion means only that the statements conform to the appropriate reporting framework (e.g., GAAP) and that the financial statements are free of material misstatement.

1.66

Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal, and governmental audit situations. You might point out to students that the distinctions among compliance, economy and efficiency, and program results audits are not always clear. The ―solution‖ is shown in the following matrix form, showing some engagement numbers in two or three cells. The required schedule follows.

Auditor Independent CPA Internal auditor Governmental (GAO) auditor IRS auditor Bank examiner

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Financial Statement 2, 10

Proprietary school‘s training expenses Advertising agency financial statements Dept. of Defense launch vehicle Municipal services Tax shelters Test pilot reporting Bank solvency Materials inspection by manufacturer States‘ reporting chemical use data Sports complex forecast

Type of Audit Engagement Economy and Compliance Efficiency 6, 8

4, 8 1, 3

Program Results

1, 3, 9

5 7

Type of Audit Economy and efficiency or program results Financial statement

Type of Auditor Governmental (GAO) auditors Independent CPAs

Economy and efficiency or program results Economy and efficiency Compliance Compliance Compliance Compliance or Economy and Efficiency Program goal

Governmental (GAO) auditors Internal auditors IRS auditors Internal auditors Bank examiners Internal auditors

Financial statement

Governmental (GAO) auditors Independent CPAs

1.67

Financial Assertions and Audit Objectives By definition, management financial statement assertions give rise to questions that can be answered with evidence. The objectives for the audit of Spillane‘s securities investments at December 31 are to obtain evidence about the assertions implicit in the financial presentation, specifically: 1.

Existence. Obtain evidence that the securities are bona fide and held by Spillane or a responsible custodian. Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under audit.

Completeness. Obtain evidence that all the securities purchase transactions were recorded.

Rights. Obtain evidence that Spillane owned the securities. Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan.

1.68

Valuation. Obtain evidence of the cost and market value of the securities held at December 31. Decide whether any write-downs to market are required by the appropriate reporting framework.

Presentation and disclosure. Obtain evidence of the committed nature of the assets, which should mean they should be in a noncurrent classification like the loan. Obtain evidence that restrictions on the use of the assets are disclosed fully and agree with the loan documents.

Internet Exercise: Professional Certification These answers will depend on the student‘s state of residence. Many states have recently reduced the experience requirements by either (1) reducing or eliminating an audit experience requirement and/or (2) reducing the experience requirement in lieu of additional education. For a quick link to each state, visit the National Association of State Boards of Accountancy (www.nasba.org).

1.69

Internet Exercise: Professional Certification The Institute of Internal Auditors does a good job explaining the benefits of becoming a certified internal auditor. The exam consists of four parts: the Internal Audit Activity‘s Role in Governance, Risk, and Control; Conducting the Internal Audit Engagement; Business Analysis and Information Technology; and Business Management Skills. You must have at least a bachelor‘s degree to sit for this exam. The Institute of Management Accountants also does a good job of explaining the benefits of the certification. The parts of the exam include Business Analysis, Management Accounting and Reporting, Strategic Management, and Business Applications. You must have at least a bachelor‘s degree to sit for this exam. The Association of Certified Fraud Examiners also does a good job of explaining the benefits of the certification. The areas of study tested on the exam include criminology and ethics, financial transactions, fraud investigation, and legal elements of fraud. You must have at least a bachelor‘s degree to sit for this exam. The Information Systems Audit and Control Association website explains the benefits of becoming certified. You must have at least an associates‘ degree to sit for this exam.

1.70

Apollo Shoes Questions 1) List three relevant facts about Apollo Shoes that you think might have an impact on the financial statement audit. 1-24 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

This question is designed to get the students to examine the Apollo Shoes Form 10K with a critical mindset. There are a number of allowable responses to this question. Three prominent responses would be: a. b. c.

Accounts Receivable increased significantly from the prior year. Inventory increased significantly from the prior year. The line of credit balance increased significantly from the prior year.

2) Define what is meant by a significant account or disclosure. A financial statement account or footnote disclosure is considered significant if there is a chance that the account or footnote disclosure could contain a material misstatement. As a result, an auditor will have to conduct some procedures on each significant account or disclosure. 3) Identify at least two significant accounts or disclosures from the financial statements of Apollo Shoes. What makes each item significant? This question is designed to get the students to examine the Apollo Shoes Trial Balance with a critical mindset. There are a number of allowable responses to this question. Two prominent responses would be: a. b.

Accounts Receivable is significant because of the magnitude of the account in relation to total assets for Apollo Shoes. Inventory is significant because of the magnitude of the account in relation to total assets for Apollo Shoes.

4) Define what is meant by a relevant assertion. A relevant assertion is "a management assertion is relevant if there is a reasonable possibility that a material misstatement exists related to that assertion for the significant account or footnote disclosure being audited.‖ 5) Identify at least one relevant assertion for each of the significant accounts or disclosures previously identified from the financial statements of Apollo Shoes. What makes each assertion relevant? Once again, there are a number of allowable responses to this question. Two responses that related back to the suggested solution for question #3 would be: a.

Valuation of Accounts Receivable is relevant because of the significant increase in receivables compared to last year. Importantly, this increase occurred without a significant increase in sales. What happened? Why are they unable to collect their receivables this year as compared to last year? Should the allowance for doubtful accounts be increased? As a result of these questions, the risk of material misstatement for this assertion is high. Existence of Inventory is relevant because the inventory balance is a material amount and the auditor must make sure that the inventory does really exist. The inventory balance increased significantly compared to last year. Why? The professional standards require that we conduct a physical inventory observation to validate the existence of inventory. As a result of these considerations, the risk of material misstatement for this assertion is high.

CHAPTER 2 Professional Standards LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises and Problems

Understand the development and source of generally accepted auditing standards.

1, 2, 3, 4

47, 48

52 (*), 53

Describe the fundamental principle of responsibilities and how this principle relates to the characteristics and qualifications of auditors.

5, 6, 7

27, 29, 35, 39, 40

54, 55, 56, 57, 62 (*), 64 (*), 65 (*), 66 (*), 67 (*), 68 (*)

Describe the fundamental principle of performance and identify major activities performed in an audit.

8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18

26, 30, 31, 32, 33, 34, 36, 37, 42, 43, 44, 45

58, 59, 60, 61, 62 (*), 64 (*), 65 (*), 66 (*), 67 (*), 68 (*)

Understand the fundamental principle of reporting and identify the basic contents of the auditors‘ report.

19, 20

41, 49, 50, 51

63, 64 (*), 65 (*), 66 (*), 67 (*), 68 (*)

Understand the role of a system of quality control and monitoring efforts in enabling public accounting firms to meet appropriate levels of professional quality.

21, 22, 23, 24, 25

28, 38, 46

52 (*), 69, 70, 71

(*) indicates that an item corresponds to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 2.1

Generally accepted auditing standards are auditing standards that identify necessary qualifications and characteristics of auditors and guide the conduct of the audit examination. The purpose of generally accepted auditing standards is to meet the following objectives of an audit examination:  

To obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to error or fraud. To issue a report on the financial statements

2.2

Currently, the PCAOB is responsible for developing standards for the audits of issuers, while the AICPA is responsible for developing standards for the audits of non-issuers.

2.3

The AICPA (through the Auditing Standards Board) has responsibility for setting standards for the audits of non-issuers. This is done through the issuance of Statements on Auditing Standards. The PCAOB has responsibility for setting standards for the audits of issuers. This is done through the PCAOB‘s issuance of Auditing Standards. While the SEC does not have responsibility for setting auditing standards per se, all PCAOB standards must be approved by the SEC.

2.4

2.5

The three fundamental principles are: 1.

Responsibilities, which involves having appropriate competence and capabilities, complying with relevant ethical requirements, maintaining professional skepticism and exercising professional judgment.

Performance, which requires auditors to obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement by: (1) planning the work and properly supervising assistants; (2) determining and applying appropriate material levels; (3) identifying and assessing the risk of material misstatement; and, (4) obtaining sufficient appropriate audit evidence.

Reporting, which requires the auditor to express an opinion (or state that an opinion cannot be expressed) as to whether the financial statements are presented fairly in accordance with the applicable financial reporting framework.

Independence in fact represents auditors‘ mental attitudes (do auditors truly act in an unbiased and impartial fashion with respect to the client and fairness of its financial statements?). Independence in appearance relates to financial statement users‘ perceptions of auditors‘ independence. Auditors can be independent in fact but not perceived to be independent. For example, ownership of a small interest in a public client would probably not influence auditors‘ behavior with respect to the client. However, it is likely that third-party users would not perceive auditors to be independent.

2.6

Due care reflects a level of performance that would be exercised by reasonable auditors in similar circumstances. Auditors are expected to have the skills and knowledge of others in their profession (known as that of a prudent auditor) and are not expected to be infallible.

2.7

Professional skepticism is a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. Professional judgment is the auditors‘ application of relevant training, knowledge, and experience in making informed decisions about appropriate courses of action during the audit engagement. Auditors are required to demonstrate professional skepticism and professional judgment throughout the entire audit process.

2.8

Reasonable assurance recognizes that a GAAS audit may not detect all material misstatements and auditors are not ―insurers‖ or ―guarantors‖ regarding the fairness of the entity‘s financial statements. The audit team provides reasonable assurance by considering various risks relating to the likelihood of material misstatements and performing audit procedures to control this risk to an acceptably low level.

2.9

An audit plan is a list of audit procedures that are performed to gather sufficient appropriate evidence on which auditors base their opinion on the financial statements. Audit plans are prepared during the planning stages of the audit.

2.10

An interim date is a date between the beginning of the year and the year-end. Performing audit procedures prior to the interim date allows the audit team to spread work over a longer period of time and focus efforts on the time period between the interim date and year-end, to allow the audit to be completed on a more timely basis.

2.11

Materiality is the dollar amount that would influence the lending or investing decisions of users; this concept recognizes that auditors should focus on matters that are important to financial statement users. Materiality should be considered in planning the audit, performing the audit, and evaluating the effect of misstatements on the entity‘s financial statements.

2.12

Auditors obtain an understanding of a client, including its internal control, as a part of the control risk assessment process primarily in order to plan the nature, timing and extent of further audit procedures. A secondary purpose is because of auditors‘ responsibilities for reporting on client‘s internal controls.

2.13

As the client‘s internal control is more effective (a lower level of control risk), auditors may use less effective substantive procedures (a higher level of detection risk). Conversely, when the client‘s internal control is less effective (a higher level of control risk), auditors must use more effective substantive procedures (a lower level of detection risk).

2.14

Audit evidence is defined as the information used by auditors in arriving at the conclusion on which the audit opinion is based.

2.15

External documentary evidence is audit evidence obtained from another party to an arm‘s-length transaction or from outside independent agencies. External evidence is received directly by auditors and is not processed through the client‘s information processing system. External-internal documentary evidence is documentary material that originates outside the bounds of the client‘s information processing system but which has been received and processed by the client. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the client‘s information processing system. Such evidence is either not circulated to outside parties at all or is several steps removed from third-party attention.

2.16

Relevance refers to the nature of information provided by the audit evidence; that is, what assertion(s) related to the account balance or class of transactions does the evidence support? Reliability refers to the extent of trust that auditors can place in evidence and is primarily influenced by the source of the evidence. The appropriateness of audit evidence is related to both relevance and reliability; that is, as evidence is more relevant and reliable, it is considered to have a higher level of appropriateness.

2.17

The source of evidence affects its reliability as follows (from most to least reliable): (1) evidence directly obtained by auditors, (2) evidence obtained from external sources, and (3) evidence obtained from internal sources.

2.18

As auditors need to achieve lower levels of detection risk, more appropriate evidence needs to be obtained. Thus, auditors should gather higher quality evidence (more reliable evidence). For example, auditors may choose to obtain evidence from external sources rather than internal sources. In addition, for lower levels of detection risk, auditors need to gather more sufficient evidence. Because sufficiency relates to the quantity of evidence, more transactions or components of an account balance should be examined.

2.19

A financial reporting framework is a set of criteria used to determine the measurement, recognition, presentation, and disclosure of material items in the financial statements. The financial reporting framework is related to auditors‘ reporting responsibilities because this framework serves as the basis against which the financial statements are evaluated and the auditors‘ opinion on the financial statements is expressed.

2.20

Four types of opinions and their conclusions:

2.21

Type

Conclusion

Unmodified opinion

Financial statements are presented in conformity with GAAP.

Adverse opinion

Financial statements are not presented in conformity with GAAP.

Qualified opinion

Financial statements are presented in conformity with GAAP, except for one or more departures or issues of concern.

Disclaimer of opinion

An opinion cannot be issued on the financial statements.

A system of quality control provides firms with reasonable assurance that the firm and its personnel (1) comply with professional standards and applicable regulatory and legal requirements and (2) issue reports that are appropriate in the circumstances. The six elements of a system of quality control are: 1. 2. 3. 4. 5. 6.

Leadership responsibilities for quality within the firm (―tone at the top‖) Relevant ethical requirements Acceptance and continuance of client relationships and specific engagements Human resources Engagement performance Monitoring

2.22

In deciding whether to accept or continue an engagement with a client, firms should consider:   

The integrity of the client and the identity and business reputation of its owners, key management, related parties, and those charged with governance. Whether the firm possesses the competency, capability, and resources to perform the engagement. Whether the firm can comply with the necessary legal and ethical requirements.

If firms decide to withdraw from an engagement, the firm should document significant issues, consultations, conclusions, and the basis for any conclusions related to the decision to withdraw. 2.23

Procedures used by firms to monitor their quality control standards include:    

Reviews of selected administrative and personnel records. Reviews of engagement documentation, reports, and the client‘s financial statements. Discussions with firm personnel Assessments of the (1) appropriateness of the firm‘s guidance materials and professional aids, (2) compliance with policies and procedures on independence, (3) effectiveness of continuing professional education, and (4) decisions regarding the acceptance and continuance of client relationships and specific engagements.

2.24

The PCAOB‘s monitoring role for firms providing auditing services to issuers includes registering public accounting firms and conducting inspections of registered public accounting firms.

2.25

The frequency of PCAOB inspections depends upon the number of audits conducted by member firms. For firms performing audits for more than 100 issuers, inspections are required on an annual basis. For those performing audits for 100 or fewer issuers, inspections are conducted every three years.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 2.26

2.27

a. b.

Correct Incorrect

c. d.

Incorrect Incorrect

Gathering audit evidence is a component of the performance principle. While reasonable assurance is related to gathering audit evidence, this is not one of the categories of principles The reporting principle relates to the contents of the auditors‘ report The responsibilities principle relates to the personal integrity and professional qualifications of auditors.

NOTE TO INSTRUCTOR: Since this question asks students to identify the concept that is not related to the ethical requirements of auditors, the response labeled “correct” is not related to the ethical requirement of auditors and those labeled “incorrect” are related to the ethical requirements of auditors. a. b.

Incorrect Incorrect

Incorrect

Correct

Due care is related to the ethical requirements of auditors. Both independence in fact and independence in appearance are related to the ethical requirements of auditors. Both independence in fact and independence in appearance are related to the ethical requirements of auditors. While professional judgment is part of the responsibilities principle, it is not related to the ethical requirements of auditors.

2.28

2.29

2.30

2.31

2.32

2.33

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

Incorrect

a. b.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

GAAS relates to the conduct of audit engagements and not overall professional services. Standards within a system of quality control are firm- (rather than auditor-) related. Generally accepted accounting principles are not an element related to professional services. International auditing standards govern the conduct of audits conducted across international borders. Relying more extensively on external evidence is related to the appropriateness (or quality) of evidence. Focusing on items with more significant financial effects on the financial statements is related to materiality. Professional skepticism is characterized by appropriate questioning and a critical assessment of audit evidence. Financial interests are most closely related to auditors‘ independence. Auditors study internal control to determine the nature, timing, and extent of further audit procedures. Consulting suggestions are secondary objectives in an audit. Information about the entity‘s internal control is, at best, indirect evidence about assertions in the financial statements. Information about the entity‘s internal control provides auditors with little opportunity to learn about changes in accounting principles. External evidence is considered to be more reliable than the inquiry of management in choice (b). Inquiry of management is a form of internal evidence, which is the least reliable form of evidence. Auditor-prepared evidence is considered to be the most reliable form of evidence. Because the entity‘s legal counsel is an external party, this form of evidence is more reliable than the inquiry of management in choice (b). Inquiry of management is the least reliable form of evidence. Although external evidence is considered to be highly reliable, auditors‘ personal knowledge (choice d) provides the most reliable form of evidence While auditor evaluation of client procedures is a reliable form of evidence, this would not be relevant to verifying the existence of newly-acquired equipment. Auditors‘ personal knowledge through physical observation provides the most reliable form of evidence; in addition, unlike evaluation of client procedures (choice c), this relates directly to verifying the existence of newly-acquired equipment. Inquiry of client personnel is internal evidence, which is the least reliable form of evidence. Prenumbered client purchase orders are an internal form of evidence, which is the least reliable form of evidence While sales invoices are documents created by external parties, the fact that these documents were received from client personnel reduces their reliability. Because the statements were received directly from outside parties, this is a more reliable form of evidence than internal forms of evidence (choices a and b) or external evidence received indirectly by the auditor (choice c).

2.34

2.35

2.36

2.37

2.38

a. b.

Incorrect Incorrect

Correct

Incorrect

Documentation of this nature would not be related to independence. While the quality of the documentation and the conclusions included in the documentation might provide information about competence and capabilities, choice (c) is more closely related to planning and supervision. Initials of the preparer and reviewer provide evidence that the documentation was reviewed, which relates to planning and supervision. While the quality of the documentation and the conclusions included in the documentation might provide information about sufficient appropriate evidence, choice (c) is more closely related to planning and supervision

NOTE TO INSTRUCTOR: Since this question asks students to identify the concept that is least related to due care, the response labeled “correct” is least related to due care and those labeled “incorrect” are more related to due care. a.

Incorrect

c. d.

Incorrect Correct

a. b.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

Incorrect

c. d.

Incorrect Correct

Due care requires the level of skills and knowledge of others in the auditors‘ profession, which would include independence in fact. Due care requires the skills and knowledge of others in the auditors‘ profession, which would include professional skepticism. Due care refers to the performance of a ―prudent‖ auditor. Reasonable assurance is related to the auditors‘ responsibility for detecting misstatements and procedures performed during the examination, not the concept of due care. Internal documents are a relatively low quality of evidence. Because these representations were received from an internal source (the president of the entity), they are a relatively low quality of evidence. While external evidence is of reasonable quality, it is of lower quality than direct personal knowledge of the auditor (choice d). Direct, personal knowledge of auditors is the most appropriate form of evidence. While it may increase auditors‘ knowledge about the client, obtaining an understanding of a client‘s internal control does not directly influence auditors‘ competence and capabilities. Obtaining an understanding of a client‘s internal control does not directly influence auditors‘ independence. Obtaining an understanding of a client‘s internal control does not directly help satisfy the quality control standard about audit staff professional development. The primary purpose of obtaining an understanding of a client‘s internal control is to plan the nature, timing, and extent of further audit procedures on an engagement. While receiving independence confirmations with respect to clients would be important in deciding to accept or continue clients, this element is more closely related to relevant ethical requirements (choice d). Receiving independence confirmations is not related to engagement performance. Receiving independence confirmations is not related to monitoring. Independence confirmations would ensure that all firm personnel are independent with respect to that firm‘s clients, which is related to the ―Relevant Ethical Requirements‖ element of a system of quality control. It would not relate to acceptance and continuance of client relationships and specific engagements (a), engagement performance (b), or monitoring (c).

2.39

2.40

2.41

2.42

2.43

a. b.

Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

The responsibility to issue a report is related to the reporting principle. The requirement to gather sufficient, appropriate evidence is related to the performance principle. The auditors‘ compliance with independence and due care is related to the responsibilities principle. The responsibility to plan an audit and properly supervise assistants is related to the performance principle. Consultation with an appraiser demonstrates due care if auditors do not have expertise in the area in question. Auditors are experts in financial matters, not areas of art (and other collectibles) valuation. GAAS applies to all audit engagements, including audit engagements for notfor-profit organizations. Because consulting an appraiser is consistent with exercising due care (choice a), this cannot be correct.

NOTE TO INSTRUCTOR: Since this question asks students to identify the topic that is not been addressed in the auditors’ report, the response labeled “correct” is not addressed in the auditors’ report and those labeled “incorrect” are addressed in the auditors’ report. a.

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

The responsibilities of the auditor and management are provided in the first paragraph of the Basis for Opinion section. Auditors provide reasonable (but not absolute) assurance in an audit engagement (this is noted in the second paragraph of the Basis for Opinion section of the auditors‘ report). A description of the audit engagement is provided in the second paragraph of the Basis for Opinion section of the auditors‘ report. The auditors‘ opinion on internal control over financial reporting is provided in the second paragraph of the Opinion section of the auditors‘ report. The concept of absolute assurance requires auditors to identify and detect all material misstatements. Professional judgment relates to the application of training, knowledge, and experience in making informed decisions. It does not specifically relate to detecting material misstatements. The reliability of audit evidence relates to the sufficiency and appropriateness of evidence. While more reliable evidence will reduce the likelihood that material misstatements will not be detected, it does not, in itself, ensure that a GAAS audit will detect all material misstatements. Reasonable assurance recognizes that an audit conducted under GAAS may fail to detect all material misstatements. The fact that the source of the evidence is internal would result in evidence being less reliable than external evidence (choice c). The fact that the source of the evidence is internal and evidence is developed under less effective internal control would result in evidence being less reliable than external evidence and environments with more effective internal control (choice c). Evidence is most reliable when the source of the evidence is external and when the evidence is developed under more effective internal control. The fact that the evidence is developed under less effective internal control would result in evidence being less reliable than when developed under more effective internal controls (choice c).

2.44 a. Incorrect The decision to physically inspect investment securities rather than obtain an external confirmation relates to the source of evidence, which affects the reliability of evidence. b. Correct The aging of accounts receivable will evaluate valuation, which is not directly evaluated through confirmation. Therefore, aging provides relevant evidence with respect to the valuation assertion. c. Incorrect The number of accounts confirmed by the auditor is related to the sufficiency of evidence, not the appropriateness of evidence (or relevance and reliability). d. Incorrect The decision to confirm a larger number of accounts following year-end relates to the timing of audit procedures, not the appropriateness of evidence (or relevance and reliability). 2.45

2.46

2.47

2.48

NOTE TO INSTRUCTOR: Since this question asks students to identify the statement that is not true with respect to the performance principle, the response labeled “correct” is not true and those labeled “incorrect” are true. a. b.

Correct Incorrect

Incorrect

Correct

Incorrect

Correct

Incorrect

b. c. d.

Correct Incorrect Incorrect

Written audit plans are required in both initial and continuing audits. Materiality should be considered in planning the audit, performing the audit, and evaluating the effects of misstatements on the entity‘s financial statements. The effectiveness of the entity‘s internal control is an important consideration in the audit team‘s assessment of the risk of material misstatement. In order to be appropriate, evidence must be both relevant and reliable. Annual inspections are only required for audit firms that audit more than 100 issuers. In a PCAOB inspection, a sample of audits as well as the firm‘s system of quality control are reviewed by the inspection team. While the deficiencies noted in sampled audit engagements are publicly disclosed, information regarding deficiencies in the firm‘s quality control are not publicly disclosed unless the firm fails to address those deficiencies within one year. All firms auditing issuers must have a PCAOB inspection. If a firm audits 100 or fewer issuers, it has an inspection every three years rather than every year. Audit procedures are particular and specialized actions that auditors take to obtain evidence during a specific engagement. Auditing standards do not apply to specific engagements, but are quality guides that apply to all audits. Interpretive publications provide guidance to auditors on the application of generally accepted auditing standards in specific situation. Statements on Auditing Standards are pronouncements issued by the Auditing Standards Board that apply to all audits of non-issuers. The PCAOB does develop Auditing Standards, but these relate to the audit of issuers. The PCAOB develops Auditing Standards for the audit of issuers. The Auditing Standards Board develops Statements on Auditing Standards. The Auditing Standards Board develops Statements on Auditing Standards.

2.49

2.50

2.51

Incorrect

Correct

Incorrect

a. b.

Correct Incorrect

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

The description of the audit examination (including a reference to PCAOB standards) is included in the second paragraph of the Basis for Opinion section. The auditors‘ conclusion with respect to the financial statements is included in the first paragraph of the Opinion section. The responsibility of auditors and management in the financial reporting process is included in the first paragraph of the Basis for Opinion section. The auditors‘ conclusion with respect to internal control is included in the second paragraph of the Opinion section. An adverse opinion is issued for material and pervasive departures from GAAP. A disclaimer of opinion would be issued only when auditors felt they were unable to reach a conclusion with respect to the fairness of the entity‘s financial statements. A qualified opinion concludes that, with the exception of a specific matter, the entity‘s financial statements are presented according to GAAP. An unmodified opinion concludes that the entity‘s financial statements are presented according to GAAP. The communication principle is not one of the fundamental principles. The performance principle relates to the conduct of the audit examination. The reporting principle is related to the contents of the auditors‘ report, which expresses an opinion on the entity‘s financial statements (or indicates that an opinion cannot be expressed). The responsibilities principle relates to the characteristics and qualifications of the auditors.

SOLUTIONS FOR EXERCISES AND PROBLEMS 2.52

AICPA and PCAOB Responsibilities a.

The audits of issuers are governed by Auditing Standards issued by the PCAOB that have been approved by the SEC. The audits of non-issuers are governed by Statements on Auditing Standards issued by the AICPA.

2.53

The AICPA (for non-issuers) and PCAOB (for issuers) examine documentation related to previous audit engagements and evaluate the audit firms‘ systems of quality control. These evaluations are referred to as peer reviews (AICPA) and inspections (PCAOB)

Professional Guidance a. b. c. d. e. f. g. h.

SAS AS N SAS B AS B AS

2.54

Independence a.

Auditors should not follow clients‘ suggestions about the conduct of an audit unless the suggestions clearly do not conflict with their professional competence, judgment, honesty, independence, or ethical standards. Where there is no disagreement about the results to be accomplished and the client‘s suggestions represent good ideas, auditors can consider these suggestions. Within professional bounds, mutual agreement with the client is acceptable. Auditors must never agree to any arrangement that violates generally accepted auditing standards or the AICPA‘s Code of Professional Conduct.

The reasons that would not support dividing the assignment of audit work solely according to assets, liabilities and income and expenses include the following: 1.

Work should be assigned to staff members by considering the degree of difficulty in relation to the technical competence and experience of individual staff members.

Sequence of work performed on an examination should be in accordance with an overall audit plan.

It is impossible to segregate work areas by major captions because often a close relationship exists among a number of accounts in more than one category. For example, interest and dividend income are normally based on an asset (investments) and interest expense is normally based on a liability (long-term debt).

Often a single form of audit documentation is desirable to provide evidence with respect to balances in accounts of various types, such as an insurance analysis supporting premium disbursements, the insurance expense portion, and the prepaid insurance balance.

Duplication of staff effort would be more likely to occur if assignments were made on such a basis.

Frequently, the scope of work regarding a single account requires simultaneous participation by the staff, such as in the observation of inventories.

Many audit operations are not susceptible to division by category, as for example studying and evaluating internal control, testing transactions, and preparing the report. c.

The audit staff member whose uncle owns the advertising agency should not be assigned to examine the client‘s advertising account. The firm is responsible for avoiding relationships which might suggest a conflict of interest. Regardless of whether this staff member could be independent and unbiased in such a situation (independence in fact), external parties will likely be influenced in their thinking by the fact that the uncle is the owner of the advertising agency (the staff member would not have independence in appearance). Even if a problem of ethics were not involved, it would be unwise for the firm to assign this staff member because the client‘s attitude could change significantly and the firm‘s position would be jeopardized if difficulties later arose in connection with the contract. Any situation in which bias exists or might arise should be avoided.

2.55

Independence a.

Independence in fact relates to the auditors‘ ―state of mind‖ and reflects an unbiased and impartial perspective with respect to the financial statements and other information they audit. Independence in appearance relates to others‘ (particularly financial statement users‘) perceptions of the auditors‘ independence.

The two general types of relationships that compromise auditors‘ independence are financial relationships (owning shares of stock or having an outstanding loan to or from a client) and managerial relationships (acting in a decision-making capacity on behalf of a client or providing advice on systems or information that will be audited).

While auditors might still be independent in fact with respect to the audit of the client, the large revenues resulting from these services create a financial interest that many users would find to be troubling. For example, consider the possibility that clients might use the revenues from these services as a bargaining tool with auditors if an issue arises during the audit engagement. Currently, no prohibitions exist on the extent of consulting services or revenues, other than the prohibition of certain types of services and the required approval of nonaudit services by the client‘s audit committee.

This would clearly pose a compromise to auditors‘ independence and would not be permitted under current guidelines. The issues in this case are (1) the fact that the auditor is directly involved with the engagement and (2) the executive-level position occupied by his or her spouse with a client.

This introduces a similar issue to (2), but would be less likely to compromise the auditors‘ independence. The major differences in this scenario are (1) the auditor is not directly involved with the engagement, (2) the level of position held by the auditor‘s relative is not at the executive level, and (3) the relationship between the auditor and other individual is not as close. Professional standards would likely not conclude that this situation would compromise the auditor‘s independence.

This represents a direct financial interest in a client. The issue is whether the fact that the staff member is not a part of the engagement team compromises his or her independence. While professional guidelines would not conclude that this situation compromises the independence of the staff member, many firms have adopted the practice of not permitting any of their professional staff to hold financial interests in their audit clients.

2.56

2.57

Professional Skepticism a.

Professional skepticism refers to a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence.

Auditors are required to maintain professional skepticism throughout the audit, including during the following stages: (1) engagement planning, (2) risk assessment, (3) audit evidence, and (4) reporting.

The strong relationships and friendships that have developed between the firm personnel and client‘s officers may lead to an increased level of trust that would reduce the likelihood of questioning and critically assessing audit evidence.

The time pressure resulting from other workload demands and deadlines related to other engagements may result in a desire to complete the audit more promptly and reduce the extent to which the firm personnel question and critically assess audit evidence.

The client‘s wishes to reduce or limit the audit fee may make firm personnel less likely to question and critically assess audit evidence, since doing so would increase the costs incurred during the audit without a corresponding increase in revenues.

Responsibilities Principle a.

Ethical requirements. Martin should consider any potential impacts of the family relationship of one of its staff accountants with the Chief Financial Officer on its ability to maintain independence in fact and independence in appearance. The important role that the Chief Financial Officer plays in the financial reporting process makes potential relationships with this individual particularly sensitive.

Competence and capabilities. The fact that Phillip, Inc. is in an industry in which Martin does not have significant experience (manufacturing) and is larger in size than most of Martin‘s clients raises potential concerns with respect to Martin‘s ability to appropriately conduct the audit of Phillip.

Professional skepticism and professional judgement. Martin appears to exhibit appropriate professional judgment and skepticism by verifying the reason for the change in auditors by contacting Phillip‘s former auditors, rather than just accepting Phillip‘s response to Martin‘s inquiries about the reason for the change.

Competence and capabilities. Martin‘s concerns about its inability to conduct an appropriate observation of Phillip‘s inventories (which are highly material to the financial statements) raises additional issues related to Martin‘s competence and capabilities beyond the industry and size of Phillip.

Professional skepticism and professional judgment. If Martin‘s proposal is accepted and Martin accepts the engagement, it should not rely on Phillip‘s representation that no transfers of inventory have occurred between locations without some form of verification and additional testing. Appropriate professional skepticism would suggest that other means of addressing this issue should be considered.

2.58

Ethical requirements. While ensuring that firm personnel are independent in fact and in appearance with respect to Phillip, Martin should consider this issue prior to submitting a proposal rather than after doing so (assuming that the proposal is accepted).

Responsibilities Principle: Planning One initial issue that is raised in this scenario is the fact that the firm is very small (one person with two assistants) and does not appear to do a meaningful amount of audit work (the problem description identifies the firm as primarily ―compiling clients‘ monthly statements and preparing income tax returns‖). In addition, the scenario notes that it would be considered a challenge to accept new audit clients. As a result, one possible response might question this firm‘s ability to conduct the proposed audit, regardless of some of the timing issues that are present in the President‘s request. From a theoretical viewpoint (and, in fact, from a practical viewpoint as well) such short notice of a request for an audit causes difficulties with planning the audit work, establishing staffing requirements, and reviewing the work; all of these features are important elements in the exercise of due care. The December 26 - January 20 period is a serious time constraint for an initial audit engagement. The greatest difficulties involve due care as well as the ability to appropriately perform the engagement (planning and supervision, determining materiality levels, identifying and assessing risks of material misstatement, and obtaining sufficient appropriate evidence). In view of the short notice and the time constraint, there may be some question as to whether an audit could be adequately completed by January 20.

2.59

Performance Principle: Evidence a.

Sufficiency refers to the quantity of evidence, which is the number of transactions or components of an account balance of class of transactions examined by the audit team. As it relates to evidence, the term appropriate refers to the quality of evidence. Appropriateness is affected by the information the evidence provides to the audit team (relevance) as well as the extent to which the audit team can trust the evidence (reliability).

Relevance refers to the nature of information provided by the audit evidence (the assertion or assertions supported by the evidence). Reliability refers to the extent of trust the audit team can place in the evidence. Relevance and reliability both affect the appropriateness of audit evidence; as the relevance and reliability of evidence increases, the appropriateness of evidence increases.

The source of evidence has in important effect on its reliability. The three sources of evidence (from most to least reliable) are: 1. 2. 3.

Evidence directly obtained by the auditor. Evidence obtained from external sources. Evidence obtained from internal sources.

As the entity‘s internal control is more effective, auditors would assess lower levels of the risk of material misstatement. This would allow them to permit a higher level of detection risk, which means that they could gather less sufficient and less appropriate evidence. In contrast, as the entity‘s internal control is less effective, auditors would assess higher levels of the risk of material misstatement. This would require auditors to control detection risk to lower levels, which means that they would be required to gather more sufficient and more appropriate evidence.

2.60

Performance Principle The important elements of the performance principle and their relation to the C. Reis Company audit are: 1.

Auditors must plan the work and appropriately supervise any assistants. Fulfilling this element would include the preparation of an audit plan for accounts receivable and reviewing it with the assistant prior to beginning the examination. These tasks were not done. Also, the completed audit documentation should have been reviewed to determine whether an adequate examination was performed. The illustration states that this procedure was followed.

Auditors must determine and apply appropriate materiality levels throughout the audit. This scenario did not address the process through which materiality levels were determined, so potential strengths and weaknesses related to materiality cannot be assessed.

Auditors must identify and assess risks of material misstatement. This element requires auditors to obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. The case presented did not reference any work on the internal control. Complete reliance upon prior-year audit documentation in lieu of an evaluation of the existing internal control is improper, because changes may have been implemented to the system and controls by the client.

Auditors must obtain sufficient appropriate audit evidence. The assistant‘s preparation of audit documentation, confirmation requests, and other procedures seem to fulfill the requirements of this standard if the audit work is properly performed and is of sufficient scope.

2.61

Performance Principle a.

Risk assessment (Evaluating the effectiveness of the client‘s internal control is used to assess control risk. Control risk, along with the inherent risk, forms the basis for the auditors‘ assessment of the risk of material misstatement).

Planning and supervision (Obtaining an understanding of the client‘s industry is performed in the planning stages of the audit examination).

The concept of reasonable assurance acknowledges that auditors cannot reduce the risk of failing to detect a material misstatement to zero. In addition, the concept of reasonable assurance is also related to the risk of material misstatement and audit evidence, since the risk of material misstatement and audit evidence will be used to limit the failure to detect a material misstatement to an appropriate (low) level. However, these processes cannot be relied upon to reduce this risk to zero.

Audit evidence (Obtaining confirmations from the client‘s customers is an example of a substantive procedure that provides external evidence, which is a highly reliable form of evidence).

Planning and supervision (Preparing a written audit plan is done in the planning stages of the audit examination).

This statement may relate to the audit evidence element, as it affects the type of audit evidence that is obtained during the examination. In addition, because auditors are required to design substantive procedures to provide reasonable assurance (but not absolute assurance), this statement is also related to reasonable assurance. Finally, the fact that auditors are concerned with misstatements that have a significant effect on financial statement users‘ decisions indicates that this statement is related to the materiality element.

This statement considers the significance of a misstatement, or materiality. In addition, the likelihood that the account balance contains a material misstatement is inherent risk, which is evaluated during the risk assessment stage of the audit.

The concept of reasonable assurance acknowledges that auditors cannot provide absolute assurance because of mistakes and misinterpretations in evaluating evidence.

2.62

2.63

Responsibilities and Performance Principles a.

While auditors typically cannot influence the susceptibility of accounts to misstatements or the effectiveness of the entity‘s internal control (both of which comprise the risk of material misstatement), this risk needs to be considered in order to determine the nature, timing, and extent of further audit procedures.

This statement is correct; if internal control is less effective, auditors are required to gather more sufficient and more appropriate evidence. However, in addition to the number of transactions and reliability of evidence, auditors should also consider the relevance of the evidence they gather and the extent to which that evidence supports the assertions of interest.

Auditors are not required to provide absolute assurance as to the fairness of the financial statements, which is what is being suggested in this statement. While it is true that a great deal of time and effort is necessary in an audit engagement, auditors are only required to provide reasonable assurance with respect to the ability to detect material misstatements.

This statement relates to the concept of materiality and is appropriate. However, it is important to note that the consideration of materiality in an audit is highly complex and requires an extremely high level of professional judgment.

While physical inspection of the stock certificates will provide more reliable evidence than confirming the certificates held with the custodian, it may not be necessary for auditors to conduct such an inspection. In many cases, a less reliable, but still effective procedure such as confirmation with the custodian would be appropriate.

Reporting Principle a.

The purpose of the auditors‘ opinion and report is to express an opinion (or indicate that an opinion cannot be expressed) as to whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.

NOTE TO INSTRUCTOR: The following response assumes that no additional reporting language is necessary (i.e., auditors issue the standard report) and that the auditors issue a separate report on the entity’s internal control over financial reporting rather than a combined report. The major sections in the auditors‘ report for an issuer, as well as the major contents of these paragraphs, are: 1.

Opinion on the Financial Statements Section:   

Identifies the financial statements and years examined examined by the audit team Expresses an opinion on the fairness of the financial statements Identifies the auditors‘ opinion and references the auditors‘ report on internal control over financial reporting

Basis for Opinion Section:    

Summarizes management‘s and the audit team‘s responsibility for the financial statements Indicates an audit was performed in accordance with PCAOB standards Provides a brief overview of an audit examination. Indicates that the audit provides a reasonable basis for the opinion.

Critical Audit Matter Section:  

Identifies matters that relate to material accounts and disclosures that involved challenging, subjective, or complex judgments. Indicates that the identified matters do not affect the opinion on the financial statements.

An unmodified opinion indicates that the financial statements are presented in conformity with GAAP. A qualified opinion indicates that that except for a relatively isolated (usually limited) matter, the entity‘s financial statements are presented in conformity with GAAP. An adverse opinion concludes that the entity‘s financial statements are not presented in conformity with GAAP. A disclaimer of opinion indicates that an opinion cannot be expressed on the entity‘s financial statements.

2.64

In the opinion paragraph of the auditors‘ report, the phrase ―in all material respects‖ indicates that materiality has been considered by the auditors in evaluating the conformity of the financial statements with GAAP.

Fundamental Principles a. b. c. d. e. f. g. h. i. j.

Responsibilities Performance Responsibilities Reporting Performance Performance Responsibilities Reporting Performance Responsibilities

2.65

Comprehensive Principles Case Study

Responsibilities 1.

Auditors are responsible for appropriate competence and capabilities to perform the audit.

It was inappropriate for Holmes to hire the two students to conduct the audit. The examination must be conducted by persons with proper education and experience in the field of auditing. Inexperienced persons can assist, if they are supervised.

Auditors are responsible for complying with relevant ethical requirements.

To satisfy the independence requirement, Holmes must be without bias with respect to the client under audit. Because of the financial interest in the bank loan, Holmes is neither independent in fact nor appearance with respect to the assignment undertaken. In addition, because of a number of actions (hiring unqualified individuals, failure to supervise those individuals, etc.), Holmes did not appear to exhibit due care.

Auditors are responsible for maintaining professional skepticism and exercising professional judgment throughout the planning and performance of the audit.

The fact that Holmes merely accepted the financial statements without questioning any evidence demonstrates lack of professional skepticism (as well as a lack of good professional judgment).

Performance 1.

The auditor must adequately plan the work and must properly supervise any assistants.

This element recognizes that early appointment of auditors has advantages for auditors and the client. Holmes accepted the engagement without considering the availability of staff. In addition, Holmes failed to supervise the assistants. The work performed was not adequately planned.

The auditor must determine and apply appropriate materiality level or levels.

There was no discussion that appropriate materiality levels were determined or applied for the audit by either Holmes or the two accounting students. Thus, compliance with this element is difficult to assess.

The auditor must assess the risk of material misstatement based on the entity and its environment.

Holmes did not study the client‘s internal control nor did the assistants. There appears to have been no audit examination at all. The work performed was more an accounting service than it was an auditing service.

The auditor must obtain sufficient appropriate audit evidence about whether material misstatements exist.

No evidence was obtained to support the financial statements. The auditors merely checked the mathematical accuracy of the records and summarized the accounts. Standard audit procedures and techniques were not performed.

Because a proper examination was not conducted, the report should indicate that no opinion can be expressed as to the fair presentation of the financial statements in accordance with generally accepted accounting principles.

Reporting 1.

Based on evaluation of the evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the auditor‘s findings or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with the appropriate financial reporting framework.

2.66

Fundamental Principles (Comprehensive) a.

This situation is related to the competence and capabilities element of the responsibilities principle. In this case, auditors can accept this engagement assuming that they take appropriate measures to obtain the knowledge necessary to perform the audit and understand important issues affecting this client. It is important to note that the existence of industry-specific accounting issues will require auditors to obtain the knowledge necessary to complete the engagement.

This situation is related to the reporting principle, which addresses the conformity of the financial statements with GAAP. If the client elects to treat these leases as operating leases in violation of GAAP, auditors should issue either a qualified or adverse opinion, depending upon the materiality of the departure from GAAP.

This situation is related to the performance principle, which indicates that the audit should be properly planned. In this case, auditors should evaluate whether the client‘s deadline will allow an audit to be properly planned and conducted according to generally accepted auditing standards. The fact that this would be an initial audit makes this possibility even more questionable than usual.

This situation is related to the performance principle, which requires auditors to obtain sufficient appropriate audit evidence. Given the low level of control risk, auditors would then proceed to perform the necessary auditing procedures, which provide the basis for their opinion on the client‘s financial statements. In this case, confirming a smaller number of customer accounts would be appropriate.

This situation is related to the responsibilities principle, which requires auditors to be independent. In this particular case, the fact that one of the partner‘s husband is an officer of the prospective client would likely result in the firm declining this particular engagement because of a lack of independence.

This situation is related to the reporting principle. Auditors should insist upon disclosure of the potential litigation and, if the client refuses, issue either a qualified opinion or adverse opinion, depending upon the materiality of the omission of the disclosures. In addition, the auditors‘ report should provide information regarding the omitted disclosures.

This situation is related to the performance principle, which requires auditors to assess the risk of material misstatement, which includes obtaining an understanding of the entity and its internal control. Once this understanding has been obtained, auditors would then proceed to perform the necessary substantive audit procedures.

This situation is related to the performance principle, which requires proper planning and supervision. An important element of supervision is critical review of work performed by persons at various levels within the firm. Because the supervisor‘s review of the work performed by the assistant indicates that the work supports the opinion on the financial statements, no further actions are necessary.

2.67

Fundamental Principles (Comprehensive) a.

Responsibilities: Auditors must consider financial relationships with prospective clients in evaluating their independence, which is related to complying with relevant ethical requirements.

Responsibilities: The critical assessment of evidence relates to professional skepticism, which is a component of the responsibilities principle.

Performance: The consideration of internal control is related to assessing the risk of material misstatement, which is a component of the performance principle.

Performance: Determining amounts that would influence the judgment of financial statement users is most closely related to the concept of materiality, which is a component of the performance principle.

Reporting: This is an appropriate form of report that could be issued by auditors if a significant scope limitation exists. The reporting principle notes that the auditors may indicate that an opinion cannot be expressed.

Responsibilities: Educational and experience requirements provide auditors with appropriate competence and capabilities, which is a component of the responsibilities principle.

Performance: The performance principle focuses on the requirement that auditors provide reasonable (and not absolute) assurance.

Responsibilities: Possessing the skills and knowledge of others in the profession characterizes due care, which is a component of the responsibilities principle.

Performance: The preparation of a written audit plan is part of the requirement for planning the audit and supervising assistants, which is a component of the performance principle.

Reporting: The issuance of a qualified opinion because of a departure from GAAP is an example of the auditors‘ responsibility for expressing an opinion on the financial statements under the reporting principle.

2.68

Fundamental Principles (Comprehensive) a.

While university-level training is important, it is also necessary that professionals continue their education throughout their careers, as accounting and auditing standards will change. In this particular case, the staff member would need to stay abreast of current developments in order to meet the competence and capabilities element of the responsibilities principle.

Auditors need to be both independent in fact and independent in appearance. While a small financial investment might not impair the auditors‘ actual state of mind (independence in fact), it is unlikely that financial statement users will perceive the auditor to be independent (independence in appearance). Professional standards would not consider the auditor independent in this case, as no direct financial interests in clients are permitted.

Professional skepticism represents a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. When employing professional skepticism, auditors will not simply accept all evidence provided and assume that clients are unquestionably honest. However, the statement that ―[y]ou really have to question everything the client tells you‖ is a bit exaggerative and goes beyond the concept of professional skepticism.

It is correct that internal evidence is generally of lower quality than external evidence. However, the necessary quality of evidence depends upon the risk of material misstatement and the effectiveness of the client‘s internal control. In this case, the staff auditor‘s statement that internal evidence is obtained because of time and cost considerations is not appropriate, unless the risk of material misstatement permits lower quality of evidence because of other reasons.

While appropriate planning will allow audits to be conducted on a timely basis, it is not appropriate for auditors to ignore transactions and events between the interim date (in this case, November 1) and the client‘s fiscal year end. Some testing would need to be performed following the year end for transactions occurring between November 1 and December 31.

While the primary purpose of evaluating internal control is to determine the nature, timing, and extent of further audit procedures, auditors must still conduct some study of internal control to ensure that the condition of the client‘s internal control has not changed from prior years. If it has, the substantive tests performed by auditors may no longer be appropriate. In addition, for issuers, auditors are required to study internal control and report on the effectiveness of the client‘s internal controls.

For departures from GAAP, the choice among opinions would be between a qualified opinion (for less material departures) and an adverse opinion (for more material departures).

While the concept of materiality does consider dollar amounts and their effects on users‘ decisions, qualitative factors also need to be considered when assessing materiality. For example, a small dollar amount (in absolute terms) may influence an entity‘s ability to meet its earnings expectations or report higher earnings than in previous years. Situations such as this need to be considered as well as the absolute dollar amount of an item in assessing materiality.

2.69

System of Quality Control a. b. c. d. e. f. g. h. i.

2.70

Leadership responsibilities for quality within the firm Engagement performance Human resources Monitoring Human resources Relevant ethical requirements Acceptance and continuance of client relationships and specific engagements Leadership responsibilities for quality within the firm Engagement performance

Evaluating Quality Control a.

PCAOB inspections involve a review of a sample of engagements conducted by a firm as well as an evaluation of that firm‘s system of quality control.

PCAOB inspections are conducted for firms that audit public clients; the frequency of PCAOB inspections is either annually (for firms auditing more than 100 issuers) or every three years (for firms auditing 100 or fewer issuers).

2.71

Internet Exercise: Public Company Accounting Oversight Board Inspection Reports NOTE TO INSTRUCTOR: If the PCAOB modifies the format of its inspection report, this solution may no longer be appropriate. The following represents the format of the PCAOB inspection reports as of Spring 2016. a.

The major information contained in PCAOB inspection reports includes the following: 

Part I: A summary of the audit engagements reviewed, audit deficiencies identified by the PCAOB‘s inspection (on an inspection-by-inspection basis), and information regarding the reviews of procedures performed during the review.

For the audit engagements reviewed, a summary of the engagements by industry and client size (revenues). For the deficiencies identified by the PCAOB, a summary of deficiencies based on the auditing standard related to the deficiency, financial statement accounts or auditing area affected by the deficiency, and summary of deficiencies by client industry.



Appendix C: Firm‘s response to the draft inspection report.



Appendix D: Summary of the auditing standards referenced in Part I.

A notable omission from the above that many users would find of interest is the results of the PCAOB‘s inspection of the firm‘s system of quality control. While this information is not provided in the portion of the report available to the ―public‖ (via the PCAOB‘s website), these results will be made public by the PCAOB if the firm does not satisfactorily address deficiencies within one year of the date of the report. The PCAOB‘s inspection of firm‘s system of quality control include practices, policies, and procedures in the following areas:     

c – f.

Management structure and processes, including the tone at the top Partner management, including allocation of partner resources and partner evaluation, compensation, admission, and disciplinary actions Risks involved in accepting and retaining audit engagements, including the application of the firm‘s risk-rating system Use of audit work of the firm‘s foreign affiliates on foreign operations of the firm‘s U.S. issuer audits Monitoring audit performance, including deficiencies in audit performance, independence policies and procedures, and responding to defects or potential defects in quality control

The answers here will depend up on the report selected by the student. It is important to emphasize that even the largest and most sophisticated firms have audit deficiencies. One interesting exercise is to randomly assign your students to reports (ensuring that all Big Four firms are covered) and compare the types and magnitude of deficiencies identified. In addition, having students evaluate whether the firm‘s response is appropriate in the circumstances is an interesting classroom exercise.

LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

List and describe the required pre-engagement activities that auditors undertake before beginning an audit engagement.

1, 2, 3

21, 33, 44

50, 51, 52, 57

Understand the importance of planning the audit engagement so that it is conducted in accordance with professional standards.

4, 5, 6, 7, 8, 11, 12

22, 23, 28, 29, 30, 31, 32, 34, 41, 43

10. Define materiality and explain its importance in the audit planning process.

9, 10

26, 34, 38

11. List and describe the eight general types of audit procedures for gathering evidence.

13, 14, 15, 16

27, 35, 36, 37, 39, 40, 42

45, 46, 47, 48, 54, 55

12. Define what is meant by the proper form and content of audit documentation.

17,18,19,20

24, 25

49, 56

SOLUTIONS FOR REVIEW CHECKPOINTS 3.1

Auditors can use the following sources of information to help decide whether to accept a new audit client: Financial information prepared by the prospective client such as: Annual reports to shareholders. Interim financial statements. Securities registration statements. Annual report on SEC Form 10-K. Reports to regulatory agencies. Inquiries directed to the prospect‘s business associates such as: Banker. Legal counsel. Underwriter. Other persons (e.g., customers, suppliers). Communication with Predecessor auditor, if any, regarding: Integrity of management. Disagreements with management. Analyses such as: Special or unusual risk related to the prospect. Need for special skills (e.g., computer or industry expertise). In addition, auditors can conduct an internals search for relationships that would compromise independence. Also, auditors can search business press articles and stories and legal files on the LexisNexis system or on the Internet for news about chairman of the board, CEO, CFO, and often other highranking officers. Auditors can engage an outside search firm (private investigators) to conduct additional searches for information. Finally, students should always remember that this is a goal-directed search for information. Simply stated, auditors are looking for information about client risk factors—companies accused of fraud, companies under SEC or other regulatory investigation, companies that have changed auditors frequently, and companies showing recent losses.

3.2

Client consent to give information to prospective auditors is required because the Code of Professional Conduct prohibits the predecessor audit firm from revealing confidential information to the prospective audit firm without consent. As you can see, the confidentiality requirement remains intact even when the auditor-client relationship ends. A prospective audit firm should inquire specifically about:    

Management‘s integrity. Disagreements the predecessor may have had with management about accounting principles and audit procedures. Communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations. The predecessor‘s understanding about the reasons for the change of auditors (particularly about the predecessor‘s termination).

3.3

The benefits of an engagement letter include helping to:    

Establish an understanding between client and public accounting firm of the terms of the engagement and the nature of the work. Avoid quarrels and misunderstandings between client and auditor. Avoid disputes over the audit fee. Avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do.

A termination letter is a letter from a former public accounting firm (fired or resigned) to a former client specifying terms for future services and the auditors‘ understanding of the circumstances related to the termination.

3.4

Prior to using internal auditors, external auditors should assess the competence and objectivity of the persons whose work the auditor plans to use. In general, the higher the degree of competence and objectivity, the greater the extent to which the auditor can use the work. Stated simply, favorable conclusions about competence and objectivity enable external auditors to accept and use more of the internal auditors‘ documentation and work. Importantly, the utilization of internal auditors‘ work cannot be a complete substitute for the external auditors‘ own procedures and evidence related to accounting judgments and the material financial statement balances.

3.5

Specialists are persons skilled in fields other than accounting and auditing—actuaries, appraisers, attorneys, engineers, and geologists—who are not members of the audit team. When a specialist is engaged, auditors must know about his or her professional qualifications, experience, and reputation. A specialist should be unrelated to the company under audit. Auditors must obtain an understanding of a specialist‘s methods and assumptions. Provided some additional auditing work is done on the data used by the specialist, auditors may rely on the specialist‘s work in connection with audit decisions.

3.6

It is important to remember that skills often reside in the minds of the persons assigned to the job. As a result, it is important to make sure that the team is comprised of the persons that possess the skills that are required to execute the financial statement audit process in an effective and efficient manner. The following positions are normally assigned to a ―full service‖ audit team: Audit engagement partner. Quality assurance (second) audit partner. Audit manager. Senior accountant. Statistical auditing specialist, if needed. Computer auditing specialist, if needed. Industry specialist, if needed. Other specialists, if needed Staff auditors. Tax partner. Tax manager. Tax accountants.

3.7

Information is material if it is likely to influence financial statement users’ decisions. Thus, material information is a synonym for important information. The emphasis is on the financial statement users‘ point of view, not the auditors‘ or managers‘ points of view. Although financial statement users are expected to have a basic knowledge of business and financial statements as well as an understanding of the limitations of the audit process, auditors remain conservative when setting the materiality level. Thus, if it is likely to influence the economic decisions of financial statement users, the information should be considered material.

3.8

On an audit engagement, the audit team uses materiality three ways: 1-55 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3.9



As a guide to planning substantive procedures (collectively referred to as the audit plan)—directing attention and audit work to those items or accounts that are important, uncertain, or susceptible to errors or frauds.



As a guide to evaluation of the evidence. Auditors use performance materiality (an amount less than materiality for the financial statements as a whole) to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed materiality for the financial statements as a whole. For example, auditors may use an amount less than overall financial statement materiality when auditing particular classes of transactions, account balances, or disclosures.



As a guide for making decisions about the audit report. An account such as inventory can be material in an audit context because of its size or its place in the financial statements. Additionally, inventory‘s importance can result from the potential for misstatement or the effect that a misstatement can have on the financial statements. There are two ways to conduct substantive tests: (1) substantive analytical procedures and (2) tests of details. When completing a substantive analytical review to gather evidence, the auditor must develop an independent expectation of what he or she thinks the account balance should be. Once this has been developed, the expectation is compared to the recorded amount. Any significant differences must be investigated and then corroborated with evidential matter to be effective. When applying a substantive test of details, the auditor must seek to understand the account balance and/or economic transactions that comprise the balance to ensure, based on valid and reliable evidence, that the amount was recorded in accordance with the applicable financial reporting framework (e.g., GAAP).

The two types of tests (analytical procedures and tests of details) are considered different in terms of effectiveness and efficiency. In general, analytical procedures are seen to be more efficient but less effective, while tests of detail are seen to be more effective but less efficient. Thus, an auditor must take great care in determining the nature of test procedure to specify in the audit plan. Importantly, the professional standards are clear that auditors can gain significant assurance from a well-designed substantive analytical procedure. As a result, some auditing firms encourage the use of analytical procedures whenever possible as a way to be more efficient. 3.10

The four cycles covered in this book, along with the primary accounts that can be identified within each of the cycles are shown as follows: Revenue and collection cycle Acquisition and expenditure cycle Production and conversion cycle Financing and investment cycle X X X X X X

X X X X X X

Inventory Fixed Assets Accumulated Depreciation Accounts Payable Accrued Expenses General Expense

X X

Cost of Goods Sold Depreciation Expense

X X X X X X X X X

3.11

Cash Accounts Receivable Allowance for Doubtful Accounts Sales Sales Returns Bad Debt Expense

Marketable Securities Bank Loans Long-Term Notes Accrued Interest Capital Stock Retained Earnings Dividends Declared Interest Expense Income Tax Expense

Vouching relates to the examination of documents. Generally, items of financial information are selected from an account recorded in the financial statements, and auditors then go backward through the accounting process to find the source documentation that supports the item selected. Typically, vouching is used to test the existence or the occurrence assertion. Tracing occurs in the opposite direction of vouching. That is, in the process of tracing, auditors select sample items from the source documentation and proceeds forward through the accounting process all the way to its final recording in the financial statements. Typically, tracing is used to test the completeness assertion. Finally, Scanning refers to the auditors scrutinizing documentation for unusual items and events. Scanning is the way auditors exercise their general alertness to unusual items and events in clients‘ documentation. In general, scanning is an ―eyes-open‖ approach of looking for anything unusual. The scanning procedure usually does not produce direct evidence itself, but it can raise questions related to other evidence that must be obtained. 1-57 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3.12

Auditors use eight general audit procedures to gather evidence: (1) inspection of records and documents (vouching, tracing, scanning), (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, and (8) analytical procedures. One or more of these procedures may be used no matter what account balance, control procedure, class of transactions, or other information is under audit. Examples will vary.

3.13

Five types of general analytical procedures and their sources: Analytical Procedures 1. Comparison of current-year account balances to balances of one or more comparable periods 2.

Comparison of the current-year account balances to anticipated results found in the company’s budgets and forecasts

Evaluation of the relationships of currentyear account balances to other current-year balances for conformity with predictable patterns based on the company’s experience Comparison of current-year account balances and financial relationships (e.g., ratios) with similar information for the industry in which the company operates Study of the relationships of current-year account balances with relevant nonfinancial information (e.g., physical production statistics)

Sources of Information Financial account information for comparable period(s) Example: Current-year Cost of Goods Sold compared to previous-year balance Company budgets and forecasts Example: Current-year Cost of Goods Sold compared to the company’s budgeted amount Financial relationships among accounts in the current period Example: Days’ Sales in Inventory Industry statistics Example: Days’ Sales in Inventory compared to industry averages Nonfinancial information such as physical production statistics Example: Days’ Sales in Inventory compared to unfilled orders

3.14

Professional standards require that analytic procedures be used during planning and during final evaluation stages of the audit; analytical procedures are optional for use as a substantive audit procedure. Remember, auditors can also use tests of detail.

3.15

A planning memorandum summarizes all important overall planning information. The plan is used as a means to document that the audit team is following generally accepted auditing standards. More specifically, an audit plan is a comprehensive list of the specific audit procedures that the audit team needs to perform to gather sufficient appropriate evidence on which to base their opinion on the financial statements. The professional standards require that the auditor plan each audit engagement, including the establishment of an overall strategy for each audit engagement. Specifically, when planning the engagement, the auditor needs to develop and document a plan that describes the nature, timing, and extent of the procedures to be performed to assess the risk of material misstatement at the financial statement and the assertion level. Next, the auditor must carefully plan the nature, timing, and extent of control tests and substantive tests that are designed to mitigate these risks to an acceptable level.

3.16

Auditors usually prepare a planning memorandum that summarizes the preliminary analytical procedures, the materiality assessment, the significant accounts and the relevant assertions about each of the specific accounts. The planning memo also usually includes information about:      

Investigation or review of the prospective or continuing client relationship. Provision of special services or reports and needs for special technical or industry expertise. Staff assignment and timing schedules. The assessed level of inherent risk. The assessed level of control risk. Significant industry or company risks.

    

3.17

The nature, timing and extent of testing of each relevant assertion for each significant account and disclosure. Computer system control environment. Utilization of the company‘s internal auditors. Identification of unusual accounting principles problems. Schedules of work periods, meeting dates with client personnel, and completion dates.

Among other items, in the permanent audit file, you would expect to find:     

Copies or excerpts of the corporate or association charter, bylaws, or partnership agreement. Copies or excerpts of continuing contracts such as leases, bond indentures, and royalty agreements. A history of the company, its products, markets, and background. Copies or excerpts of stockholders, directors, and committee minutes on matters of lasting interest. Continuing schedules of accounts whose balances are carried forward for several years, such as owners‘ equity, retained earnings, partnership capital, and the like.  Copies of prior-years financial statements and audit reports.  Client organization chart. 3.18

Among other items, in the current audit file, you would expect to find:               

Engagement letter. Staff assignments. Memoranda of conferences with management. Memoranda of conferences with the director‘s audit committee Preliminary analytical review procedures. Risk assessment procedures. Materiality assessment. Engagement-planning memorandum Audit engagement time budget. Internal control understanding and testing. Audit plans. Trial balance of general ledger accounts. Substantive analytical procedures. Substantive test of details procedures. Final procedures to complete the audit.

3.19

PCAOB Auditing Standard 1215 defines audit documentation as the written record of the basis for the auditor‘s conclusions that provides the support for the auditor‘s representations, whether those representations are contained in the auditor‘s report or otherwise. The most important facet of the current audit evidence documentation files is the requirement that the working papers provide the basis for the auditors‘ conclusions. The documentation must record the management assertions that were audited (book values or qualitative disclosures), the evidence gathered about them, and final conclusions. Professional audit standards require the audit documentation to show that (1) the client‘s accounting records agree or reconcile with the financial statements, (2) the work was adequately planned and supervised, (3) a sufficient understanding of the client‘s internal control was obtained, and (4) sufficient appropriate audit evidence was obtained as a reasonable basis for an audit opinion. Of course, the audit documentation is sufficient to show that the financial statements conform to the relevant accounting framework and that the disclosures are adequate. The audit documentation also should explain how exceptions, unusual accounting questions, and findings contradictory to the audit team‘s final conclusions were resolved or treated. In addition, the resolution of any differences among audit team members must be documented. Taken altogether, these features should demonstrate that all auditing standards were observed and executed.

3.20

PCAOB Auditing Standard 1215 (AS 1215) requires that audit documentation, including work papers and other documents that form the basis of the engagement, be retained for seven years following the conclusion of the engagement (usually the audit report release date). AS 1215 also stresses that audit documentation including discussion and subsequent resolution of differences in professional judgment among the audit team members be retained. Although the AS 1215 requirements are only for public companies, most public accounting firms use the same requirements for their nonpublic clients. For public company audits, the professional standards also require that all documentation must be finalized within 45 days of the audit report‘s release date. With sufficient (documented) justification, auditors may subsequently add, but may not remove, documentation after the 45-day period.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 3.21

3.22

3.23

Incorrect

Correct

Incorrect

b. c.

Incorrect Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

The prospective auditor must take responsibility for obtaining the client‘s consent for the predecessor to give information about prior audits. However, since response (b) and (c) are also correct, response (d) is the correct answer. Cooperation from the predecessor is expected. However, since response (a) and (c) are also correct, response (d) is the correct answer. Cooperation includes obtaining copies of some or all of the predecessor auditors‘ documentation. However, since response (a) and (b) are also correct, response (d) is the correct answer. All of the above answers are correct. Thus, this is the correct answer. Although strongly encouraged, U.S. GAAS do not explicitly require that auditors explain their understanding of the client‘s business in writing. Client consent does not have to be documented in writing. A written audit plan is required to be documented by U.S. GAAS (AU-C 300.14). Written time budgets and schedules may be a good idea, but they are not required to be documented in writing. Audit documentation is necessary to document compliance with GAAS. Extracts of contracts should go in the permanent file. While independence is clearly an important consideration, it is not a factor that dictates the quantity, type and content of audit documentation. Materiality judgments will affect the amount of evidence shown in audit documentation.

3.24

3.25

3.26

3.27

3.28

3.29

3.30

Correct

Incorrect

b. c. d.

Incorrect Incorrect Correct

Incorrect

Correct

Incorrect

a. b.

Incorrect Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Since this is evidence that relates directly on the year under audit, the current file is appropriate. Evidence that relates directly to only the year under audit is usually not in the permanent file. The administrative audit documentation does not contain current-year evidence about particular balances. The planning memo does not contain evidential matter of this type. Internal control analysis for the current year would likely be found in the current file. The latest engagement letter would likely be in the current file. Memoranda of conference with management would likely be in the current file. Excerpts of the corporate charter and bylaws would not change often and would therefore likely be found in the permanent file. Materiality determination does help to concentrate the audit work where it is most needed. Materiality determination helps auditors to do just the right amount of work to be convinced that no material misstatement exists and not overaudit. The kind of opinion to issue cannot be determined until all the evidence is obtained and evaluated. Materiality determination helps auditors to do just the right about of work to be convinced that no material misstatement exists and not underaudit. All CAATs are not in the same computer language. CAATs can be transported and used on different types of clients that utilize different types of computing systems. This is not true. Input controls are important and need to be audited separate from the use of CAATs. The use is the means or the method to accomplish testing, but the complete set of audit procedures can rarely be done all using CAATs. Client cooperation should be specified in the engagement letter. This is a key purpose of the letter. Technical details of the audit process are not contained in the engagement letter. Specification of litigation in progress are not covered in the engagement letter. They are handled with an attorney‘s letter of confirmation. Client representations about board minutes should be in the client‘s written representation letter, not in the engagement letter. The auditors‘ report should not mention the fact that a specialist was used unless the specialist‘s findings affect the auditors‘ conclusions. The auditors‘ report should only mention the use of the specialist when the specialist‘s findings affect the auditors‘ conclusions. The auditors‘ report need not mention the use of a specialist if the auditors decide not to take responsibility for the specialist‘s findings. The auditors‘ report should mention the specialist only if Vandalay does not agree with the specialist‘s findings, resulting in an opinion other than unqualified. Interviewing internal auditors about their reporting responsibilities would assist the audit team in determining whether the internal auditors were objective but would provide little evidence of related-party transactions.

3.31

3.32

3.33

3.34

3.35

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Reviewing accounting records for nonrecurring transactions occurring near yearend would raise suspicions of fraud but not necessarily related-party transactions. Inspecting communications with the client‘s legal counsel regarding recorded contingent liabilities would be helpful in determining contingent liabilities. Scanning the minutes for significant transactions with members of the board of directors would be helpful in identifying transactions with parties related to the client because transactions with board members are likely to be discussed during the board meeting and board members are related parties. A report to the audit committee on the results of testing of internal control over cash receipts would typically occur after the entire period could be tested and therefore would be written after the balance sheet date. Confirmation letters to vendors confirming the amounts they owe to the client are part of substantive procedures performed on balance sheet account amounts. An attorney‘s letter regarding contingent liabilities would be written as close to the end of fieldwork as practicable. An engagement letter would be written before accepting an engagement, and therefore before the balance sheet date. Surprise counts of the client‘s petty cash fund may occur during planning but are more typically performed close to the balance sheet date. Reporting internal control deficiencies to the audit committee would typically occur after internal control testing was complete. Performing a search for unrecorded liabilities would be performed as a substantive procedure after planning. Identifying related parties is an important part of the audit planning process. Prior to accepting a new audit engagement, an audit firm should attempt to contact the predecessor auditor. But because (b) and (c) are also correct, letter (d) is the correct response. Prior to accepting a new audit engagement, an audit firm should evaluate the integrity of management. But because (a) and (c) are also correct, letter (d) is the correct response. Prior to accepting a new audit engagement, an audit firm should assess the firm‘s resources to ensure sufficiency. But because (a) and (b) are also correct, letter (d) is the correct response. Prior to accepting a new audit engagement, an audit firm should (a) attempt to contact the predecessor auditor, (b) evaluate the integrity of management, and (c) assess the firm‘s resources. So, all of the above is the correct response. An audit plan does not specify audit standards. When applicable, all the GAAS are relevant throughout the audit process. This is exactly what an audit plan consists of – that is, an audit plan contains specifications of procedures the auditors believe appropriate for the financial statements under audit. Documentation of the assertions under audit, the evidence obtained, and the conclusions reached describe audit documentation found in the current file, not audit plans. Reconciliation of the account balances in the financial statements with the account balances in the client‘s general ledger is one element of the content of audit documentation found in the current file, not audit plans. These accounts are part of the acquisition cycle. These accounts are part of the conversion cycles. These accounts are part of the revenue cycle.

Incorrect

These accounts are part of the financing and investment cycle.

Incorrect

Correct

Incorrect

It is not possible find an unrecorded item by looking at the amounts that were recorded in the financial statement balances. When testing the completeness assertion, an auditor starts with the potentially unrecorded items and then traces them forward to the financial statements. However, this is not a test of the existence assertion. By starting with the amounts recorded in the general ledger, you can find evidence of existence of recorded amounts by selecting items that have actually been recorded (in the general ledger) and then examining supporting original transaction documents for the amounts recorded. Selecting from the supporting original transaction documents and going to the general ledger is an audit for the completeness assertion, not the existence assertion.

Incorrect

Correct

Incorrect

3.38

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Materiality may be a qualitative assessment rather than quantitative or both. Materiality may be a quantitative assessment rather than qualitative or both. AICPA guidelines do not state exactly how judgments should be made. Most definitely, materiality is always a matter of professional judgment.

3.39

Incorrect

Correct

The audit team would be concerned if key factors are not consistent with prior periods. The audit team would be concerned if key assumptions are not similar to industry guidelines. The audit team would be least concerned about measurements that are objective and not susceptible to bias. Evidence of a systematic bias, whether aggressive or conservative, would be of most concern to the audit team.

a. b.

Incorrect Correct

Incorrect

3.36

3.37

3.40

Confirmation of accounts receivable are selected from recorded amounts and thus give the auditor no chance for selecting unrecorded amounts; responses do not produce evidence of collection so valuation is not correct. Confirmation yields some evidence of rights (ownership); however, responses do not produce evidence of the probability of collection so valuation is not correct. Confirmation of accounts receivable does produce evidence of existence because the customer is admitting that it owes the client money and some evidence of rights to the accounts receivable amount is also supported because the customer is admitting that it owes the client the money (thus, they own the receivable). Confirmations produce evidence about existence but not completeness because the items are selected from the list of accounts receivable recorded on the balance sheet.

The testing of cutoff activities is an example of a substantive test of details. One example of an analytical procedure is when auditors evaluate financial statement accounts by developing expectations about what an account balance should be based on an analysis of relevant financial and nonfinancial data. When examining the inventory balance, the auditor would expect a lower balance if there was significant sales activity. Thus, this is an example of an analytical procedure. The projection of a deviation rate of a statistical sample to the population is an example of a step taken following the completion of a test of detail. This topic is covered in detail in Module E. The reconciliation of physical inventory counts to the perpetual records and the general ledger is an example of a test of details.

3.41

3.42

3.43

3.44

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Making inquiries of the client‘s lawyer concerning pending litigation is a step that is carried out during the audit. Importantly, the step is typically finalized during the final stages of the audit. Thus, it would not be completed during planning. Performing cutoff tests of cash receipts and disbursements is a step that is carried out during the testing phase of the audit. Thus, it would not be completed during planning. Comparing the financial information with nonfinancial operating data is a step that may be completed during preliminary analytical procedures. This is done during the planning phase of the audit. Recalculating the accruals and deferrals is a step that is carried out during the testing phase of the audit. Thus, it would not be completed during planning. The completion of preliminary analytical procedures is focused on the financial statements and is unrelated to control testing. Control tests are designed to test whether the internal control procedures are being completed as they were designed by the client. The use of financial and nonfinancial data aggregated at a high level is commonly used during preliminary analytical procedures. Preliminary analytical procedures do not involve the comparison of assertions developed by management to ratios developed by auditors. During the audit, management makes assertions about the financial statement balances and auditors test those assertions. However, the response does not relate to the completion of preliminary analytical procedures. The preliminary analytical procedures completed during planning are not used to develop a preliminary judgment about materiality. If the internal auditor is evaluated as both competent and objective; the professional auditing standards allow the independent auditor to perform relatively low risk tests, like certain tests of internal control. If the internal auditor is evaluated as both competent and objective; the professional auditing standards allow the independent auditor to perform relatively low risk tests. However, the audit of a major subsidiary would likely be too risky and important for the independent auditor to rely on the internal auditor‘s testwork. If the internal auditor is evaluated as both competent and objective; the professional auditing standards allow the independent auditor to perform relatively low risk tests. As long as they are competent and objective, their lack of independence would not prevent the independent auditor from assigning tasks to the internal auditor. If the internal auditor is evaluated as both competent and objective; the professional auditing standards allow the independent auditor to perform relatively low risk tests. These low risk tests could be either analytical procedures or test details. This is not a major risk. In fact, it is quite common for audit staff members to have to be rescheduled to cover a new audit client. As a result, this is not an issue of concern. This is a major risk factor and is likely to be enough for an auditor to not accept an audit engagement. Why is there a scope limitation required? Is the potential client trying to hide a material fact (or a material misstatement) from the auditor? Given that there is a scope limitation, the auditor would have to think long and hard about whether to accept the engagement. This is not a major risk. In fact, it is quite common for an auditor to have to hire a specialist for one audit area. As a result, this is not likely to be a major issue of concern.

Incorrect

This is not a major risk. In fact, this would be a factor that would make the auditor more likely to accept the client. As a result, this is a positive factor and would not be an issue of concern.

SOLUTIONS FOR EXERCISES AND PROBLEMS 3.45

General Audit Procedures and Financial Statement Assertions

Audit Procedures a. Inspection of records or documents (vouching) b. Inspection of records or documents (tracing) c. Inspection of records or documents (scanning)

d. Inspection of tangible assets e. Observation f. Confirmation

PCAOB Assertions Existence or occurrence

ASB Assertions Existence, occurrence

Completeness

Raises questions that may be relevant to all assertions but may not produce actual ―evidence.‖ Because it is performed on recorded amounts, it works best for existence or occurrence, valuation and allocation, rights and obligations, and presentation and disclosure. When applied to source documents, it might work for the completeness assertion. Existence or occurrence, valuation Existence or occurrence, valuation Existence or occurrence Rights (ownership) Valuation (sometimes) Completeness (sometimes)

Existence Occurrence Valuation and allocation Rights and obligations Completeness Accuracy Classification

g. Inquiry

All assertions; however, responses typically yield more assertions that in turn are subject to audit with corroborating evidence.

h. Recalculation i. Reperformance j. Analytical procedures

Existence, valuation Valuation Existence or occurrence Valuation Completeness

Existence, valuation Existence, valuation Existence Rights (ownership) Valuation (sometimes) Completeness (sometimes). All assertions; however, responses typically yield more assertions that in turn are subject to audit with corroborating evidence Existence, valuation Valuation Existence Occurrence Valuation Completeness

3.46

Audit Procedures Audit Procedures specifically refer to the methods or techniques used by auditors in the conduct of the examination to gather evidence. There are eight categories of procedures that are typically used by auditors. They are listed below with examples. Example responses will vary per student: (1a)

Document inspection (vouching)  Find brokers‘ invoices and canceled checks showing agreement with record amounts for securities investments.

(1b)

Document inspection (tracing)  Select a sample of shipping documents and trace them to sales invoices, sales journal recording, and posting to general ledger.

(1c)

Document inspection (scanning)  Scan expense accounts for credit entries.  Scan payroll check lists for unusually large checks.

(2)

Inspection of tangible assets  Verify existence of fixed assets by locating them.

(3)

Observation  Observe test counting of client‘s physical inventory taking.

(4)

Confirmation  Obtain accounts receivable confirmations.  Obtain client‘s lawyer‘s letter.

(5)

Inquiry and written representations  Ask client personnel about accounting events.  Complete an internal control questionnaire.  Obtain written client representation letter.

(6)

Recalculation  Recompute the client‘s calculation of depreciation expense.

(7)

Reperformance  Analyze valuation of receivables by re-aging them by due date.

(8)

Analytical procedures such as any example that fits one of these  Compare financial information with that of prior periods.  Compare financial information with budgets and forecasts.  Study predictable financial information patterns (e.g., ratio analysis).  Compare financial information to industry statistics.  Study financial information in relation to nonfinancial information.

3.47

Confirmation Procedure a.

An audit confirmation is a procedure that is widely used in auditing and refers to direct correspondence by the auditor with independent parties. It can produce evidence of existence and ownership and sometimes even provide some evidence related to valuation and even cutoff. Auditors typically limit their use of confirmation to balances about which outside independent parties could be expected to provide accurate and reliable information (like financial institutions).

The two main characteristics a confirmation should possess are: (1) The party supplying the information requested must be knowledgeable and independent (i.e., must have knowledge of information of interest to the auditors and must be outside the scope of influence of the organization being audited). (2) The auditors must obtain the information directly from the informed party. In addition, the auditors must maintain control (at all times) over the mailing and receipt of confirmation requests. To be considered competent evidence, the client cannot have an opportunity to handle confirmation requests at any point in the process.

3.48

Potential Audit Procedure Failures This is a very open-ended discussion topic. Students‘ responses could be quite varied depending on their experience and imagination. The best classroom strategy is to start with one of the procedures and then list the students‘ suggestions on the chalkboard. The discussion can become very lively!

3.49

Audit Documentation a.

(1)

Audit documentation is the auditors‘ record of the procedures performed and conclusions reached in the audit. The functions of audit documentation are to aid the CPA in the conduct of the audit work and to provide support for the auditor‘s opinion and compliance with auditing standards.

(2)

Audit documentation can be classified in two categories: (1) permanent files (which contain information that is relevant to ongoing client relationships) and (2) current files (which relate to just one year of the client relationship). The documentation (usually in the form of either electronic files or hard copy work papers) should contain detailed support for the decisions regarding planning and performing the audit, procedures performed, evidence obtained, and conclusions reached.

The factors that affect the auditors‘ judgment of the type and content of the audit documentation for a particular engagement include: (1) (2) (3) (4) (5)

The nature of the auditors‘ report. The nature of the client‘s business. The nature of the financial statements, schedules, or other information on which the auditors are reporting and the materiality of the items included therein. The nature and condition of the client‘s records and internal controls. The needs for supervision and review of work performed by assistants.

Evidence that should be included in audit documentation to support auditors‘ compliance with generally accepted auditing standards includes:

(1) (2) (3) (4) (5)

3.50

The financial statements or other information on which the auditors are reporting were in agreement or reconciled with the client‘s records. The client‘s system of internal control was reviewed and evaluated to determine the nature, timing, and extent of audit procedures. The audit procedures performed in obtaining audit evidence for evaluation. How exceptions and unusual matters disclosed by audit procedures were resolved or treated. The auditors‘ conclusions on significant aspects of the engagement with appropriate commentaries related to each of the relevant financial statement assertions for each significant account and disclosure.

Each year, the audit team should perform an audit that allows the auditor to conclude that there are no material misstatements in the financial statements or disclosures. This should be completed in the most efficient manner possible, without sacrificing effectiveness, and the prior year‘s audit plans may aid in doing this. Those audit plans ordinarily contain information useful in the current examination (such as descriptions of the unique features of a client‘s operations or records, a formalized sequence of audit steps in logical order, and approximate time requirements to perform various phases of the work.) The audit team should decide whether to use aspects of the prior year audit plan or prepare a new audit plan entirely.

Communications between Predecessor and Successor Auditors The procedures Anderson, Olds, and Watershed, CPAs (AOW) should follow prior to accepting the engagement include the following: (a) Explain to Lancaster the need to inquire of Smith & Smith and request permission to make such inquiries. (b) Ask Lancaster to authorize Smith & Smith to respond fully to all inquiries because Smith & Smith would be prohibited from disclosing confidential information without former client permission. (c) Advise Smith & Smith of Lancaster‘s decision to change auditors. Advising Smith & Smith would be a good business judgment as well as an act of professional courtesy. (d) Make reasonable inquiries of Smith & Smith regarding matters that will aid in deciding whether to accept the engagement. (AOW should ask about facts that might bear on the integrity of management, disagreements with management about accounting and auditing matters, and Smith & Smith‘ understanding of the reason[s] for the change of auditors.) (e) If Smith & Smith does not respond fully to AOW‘s questions, consider the implications of the limited response in deciding whether to accept the engagement. (f) After weighing all information received from Smith & Smith, inform Lancaster that a first-time audit is more time consuming than a recurring audit because the new audit team is generally unfamiliar with the client‘s operations and does not have the benefit of past knowledge of company affairs to use as a guide. (g) Discuss with Lancaster the estimated required audit time and fee arrangement with a clear explanation of the purpose and scope of the audit. Any work that can be done by client personnel should also be discussed so that excess audit time might be eliminated and proposed report deadlines can be reasonably met.

(h) To satisfy AOW‘s quality control objective, use procedures such as reviewing Apollo‘s financial statements; inquiring of third parties such as Apollo‘s banks, legal counsel, investment bankers, and others in the business community as to Apollo‘s reputation; and evaluating AOW‘s ability to serve Lancaster and Apollo properly with reference to industry expertise, size of engagement, and available staff. (i) Accept the engagement and confirm the understandings in an engagement letter if AOW has no reservations and after all significant factors have been considered, discussed, and agreed to. 3.51

Predecessor and Successor Auditors Wells & Ratley (W&R) needs to initiate communications with both predecessor auditors. The situation is unusual, but W&R needs to obtain complete information from all predecessors involved since the last audit (2019 financial statements). Both Canby & Co. and Albrecht & Hubbard (A&H) are predecessors. (If Canby & Co. had completed the 2020 audit and W&R had been hired to perform the 2021 audit, then Canby & Co. would be the only predecessor. A&H would be history.) Inquiry of only one of the predecessors would not result in complete information because the circumstances surrounding each auditor change may be different. The two predecessors, having served at different times and for different lengths of time, may have different knowledge about Allpurpose Loan Company and its president. If the company is public and subject to SEC reporting requirements, forms 8-K for both changes should have also been filed.

3.52

Client Selection a.

The sources of information and types of inquiries may include:

Financial information prepared by the prospective client Annual reports to shareholders. Interim financial statements. Securities registration statements. Annual report on SEC Form 10-K. Reports to regulatory agencies. Inquiries directed to the prospect‘s business associates Banker. Legal counsel. Underwriter. Other persons (e.g., customers, suppliers). Predecessor auditor, if any, communication regarding Integrity of management. Disagreements with management. Analysis Special or unusual risk related to the prospect. Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would compromise independence

In addition, auditors can search business press articles and stories and legal files on the Lexis-Nexis system or on the Internet for news about chairman of the board, the CEO, the CFO, and often other high-ranking officers. Auditors can engage an outside search firm (private investigators) to conduct additional searches for information. Auditors are looking for information about client risk factors: companies accused of fraud, subjected to SEC or other regulatory investigation, changed auditors frequently, and incurred recent losses.

3.53

Yes. AICPA Quality Control Standards require firms to investigate all prospective audit clients.

Students can decide this acceptance question either way although the brief facts prejudice the conclusion toward nonacceptance. The CPA‘s own firm decided to resign only 10 years ago, presumably over matters of owner–manager integrity, yet, Mr. Shine appears to be a respected member of his new community. Maybe his cavalier accounting attitude is behind him. Then again, maybe it is not. This is something that the auditor will have to determine.

Using the Work of Internal Auditors a.

Control risk assessment: Tyler‘s work [internal auditing] may be relevant to North [external auditor] in obtaining a sufficient understanding of the design of General‘s internal control policies and procedures, in determining whether they have been placed in operation, and in assessing risk. Because an objective of most internal audit functions is to review, assess, and monitor internal control policies and procedures, the procedures performed by Tyler in this area may provide useful information to North. Substantive auditing: Tyler‘s work may also provide direct evidence about material misstatements in assertions about specific account balances or classes of transactions. Therefore, Tyler‘s work may be relevant to North in planning substantive procedures. Consequently, North may be able to change the nature, timing, or extent of certain procedures. North may request direct assistance from Tyler. This direct assistance relates to work North specifically requests Tyler to perform to complete some aspect of North‘s work.

Efficiency: After concluding that Tyler‘s work is relevant to North‘s audit of General‘s financial statements, North should consider whether it would be efficient to consider how Tyler‘s work might affect the nature, timing, and extent of North‘s audit procedures. If so, North should inquire as to Tyler‘s competence and objectivity in light of the intended effect of Tyler‘s work on North‘s audit. Competence and objectivity: North ordinarily should inquire about Tyler‘s organizational status within General and about Tyler‘s application of the professional internal auditing standards developed by the Institute of Internal Auditors. North also should ask about Tyler‘s internal audit plan, including the nature, timing, and extent of the audit work performed. Additionally, North should inquire about Tyler‘s access to General‘s records and whether there are any limitations on the scope of Tyler‘s activities.

3.54

Using the Computer to Discover Intentional Financial Misstatements in Transactions and Account Balances 1.

Inventory write-downs for obsolete and damaged goods were deferred. Scanning. Scan inventory records on the date of issue filed and select old last-issue dates for further investigation regarding need to write down or write off.

The sales entry system was kept open after the quarterly and annual cutoff dates, recording sales of goods shipped after the cutoff dates. Analytical procedures. Summarize and resequence sales data by shipment date or shipping document number to detect next-period shipments recorded in the accounting period under audit and then perform the next procedure. Confirmation. Select and print information about these customers regarding accounts receivable confirmation at the cutoff date.

Transactions coded as leases of office equipment were recorded as sales. Scanning. Scan the sales file on the transaction code field to detect the leased equipment recorded as sales (then examine the underlying source documentation).

Shipments to branch offices were recorded as sales. Scanning. Scan the customer name or code field for comparison to known names or codes used for branch offices (select matches for more document examination). Analytical procedures. To accomplish the same purpose, compare data on separate files—branch name and code file—to sales customer name and code fields.

Vendors‘ invoices for parts and services were not recorded until later, but the actual invoice date was faithfully entered according to accounting policy. Document examination (limited). Enter balances from period-end vendor statements and compare to the company‘s accounts payable records. Analytical procedures. Summarize the subsequent-period accounts payable entries on the invoice date field to find the total of invoices recorded late.

3.55

Inspection of Documents and Records a.

1. Internal document – the receiving report is created (i.e., filled out) in the receiving department for the client when goods are received. It is an internal document. 2. External-Internal document – the customer purchase order is generated at the customer and then sent to the client. It is given to the auditor by the client, and is therefore an external-internal document. 3. External document – bank statements received directory from the bank have not had contact with the client and are therefore external documents. 4. Internal document – Sales invoices are generated and the client and a copy is given to the customer. A copy is maintained at the client. As the invoice is generated at the client and copies are maintained by the client, this is an internal document. 5. External-Internal document – Utility bills are generated outside of the client organization, however are obtained from the client. Therefore, they are considered external-internal documents. 6. Internal document – Budgets are generated and used internally. 7. External-Internal document – Insurance policies are generated outside of the organization. A copy of the policy is most likely obtained from the client, and therefore would be considered an externalinternal document.

8. Internal document – A remittance advice is the portion of the bill a customer returns to the client with payment. While remittance advices are considered internal documents, the document was mailed to a third party and returned. Therefore, remittance advices and other internal documents that are circulated outside of the organization are considered to be more reliable evidence than those that are created and maintained internally. b. External documents are considered more reliable than internal documents because they are received directly from an external party and therefore the client has not had the opportunity to alter the documents. External-internal documents are considered less reliable than internal documents. Although generated externally, these documents were received and maintained at the client, therefore the opportunity to alter the documents existed. Strong internal controls increase the reliability of internal documents. Internal documents that have been seen and/or verified by an external party are also considered more reliable.

3.56

Audit Documentation 1. 2. 3. 4. 5. 6. 7.

3.57

Current year file Permanent file Permanent file Current year file Current year file Current year file Permanent file

Pre-engagement Activities Apple‘s 10-K can be found at https://investor.apple.com/sec-filings/default.aspx. This is a very openended question. Students‘ responses could be quite varied depending on their experience and imagination. The best classroom strategy is to start with soliciting student responses for what they consider a red flag indicator and why they believe this is an issue. Similarly, solicit why they identify characteristics as desirable. What one student believes is a red flag, others might find to be a desirable characteristic!

CHAPTER 04 Management Fraud and Audit Risk

LEARNING OBJECTIVES

Review Checkpoints

13. Define audit risk and describe how it

Multiple Choice

1, 2, 3, 4

25, 26, 27, 28, 37

5, 6, 7, 8

20, 21, 22, 23, 29,

Exercises, Problems, and Simulations

57, 59

can be broken down into the three separate components of the audit risk model to help assess and respond to such risks during the audit planning process.

14. Explain auditors‘ responsibility for

60, 63

9, 10, 11, 12

24, 35, 39, 40, 47

50, 51, 52, 54, 58

13, 14, 15, 16, 17

30, 31, 32, 33, 34, 43, 44, 45, 46

49, 53, 55, 56, 61, 66, 67, 68

fraud risk assessment and define and explain the differences among several types of fraud and errors that might occur in an organization. 15. Explain an auditor's responsibility to

assess inherent risk, including a description of the type of risk assessment procedures that should be performed when assessing inherent risk on an audit engagement. 16. Understand the different sources of

information and the audit procedures used by auditors when assessing risks, including analytical procedures, brainstorming, and inquiries.

17. Explain how auditors complete and

document the overall assessment of inherent risk. 18. Explain auditors‘ responsibilities with

respect to a client‘s failure to comply with laws or regulations. 19. Describe the content and purpose of an audit strategy memorandum.

38, 41, 42

SOLUTIONS FOR REVIEW CHECKPOINTS 4.1

Audit risk is the probability that an audit team will express an inappropriate opinion when the financial statements are materially misstated. Audit risk is a combination of the other risks: Audit risk = Risk of material misstatement x Detection risk. Risk of material misstatement = Inherent risk x Control risk. ―Audit risk in an overall sense‖ refers to the audit taken as a whole and the probability that the auditors will issue an inappropriate opinion on financial statements. Generally, this is the risk of giving the standard unmodified report when the financial statements contain material misstatements or the report should be qualified or modified in some manner. ―Audit risk applied to individual account balances and disclosures‖ refers to the probability that a misstatement exists in a particular account balance or disclosure at least equal to the tolerable misstatement assigned to the audit of that balance remains. This version of audit risk is applied at the individual account balance level or disclosure and is used to help plan the procedures to be completed on the audit. 1-73 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4.2

Risk of material misstatement—the likelihood that material misstatement(s) may have entered the accounting system and not been detected and corrected by the client‘s internal control. It is the combination of inherent risk and control risk. The audit risk model is: Audit risk = inherent risk x control risk x detection risk, the combination of inherent and control risk is known as the risk of material misstatement. Inherent risk is the probability that material errors or frauds have entered the accounting information system. This risk is expressed without regards to internal controls. Control risk is the probability that the client‘s system of internal control will fail to prevent or detect material misstatements provided that they enter the accounting information system in the first place. Audit Risk is the probability that an audit team will express an inappropriate opinion when the financial statements are materially misstated. It is the combination of risk of material misstatement and detection risk. Detection risk is the probability that the auditor‘s own procedures will fail to find material errors and frauds provided any have entered the system and have not been detected or corrected by the client‘s internal control system.

4.3

The auditor uses the Audit Risk Model to determine the nature, timing, and extent of audit procedures by evaluating the risk of material misstatement for each relevant assertion related to each significant account and disclosure. Once the risk of material misstatement has been assessed, the auditor can determine the resulting required detection risk that can be accepted, given the assessment of the risk of material misstatement. Stated differently, the auditor will select the mix of substantive procedures that are needed to ―set‖ detection risk at a level that is needed given the assessed level of the risk of material misstatement for each assertion.

4.4

When thinking about the nature, timing and extent of procedures to be performed, it is helpful to consider the two categories of substantive procedures. The two categories of substantive procedures are (1) tests of detail of transactions and balances and (2) substantive analytical procedures, which study plausible relationships among financial and nonfinancial data. The nature of audit procedures refers to the type of tests that the auditor plans to use to detect errors and fraud. In general tests of details are more effective than substantive analytical procedures. However, in general, the substantive analytical procedures are more efficient than tests of details. Thus, when considering the nature of tests to be performed, if an auditor wants to set detection risk lower, he/she is likely to complete more tests of details, relative to analytical procedures. The timing of audit procedures refers to when they are performed, usually at (1) interim period or at (2) year-end. However, timing may have other aspects such as surprise 1-74 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

procedures (unannounced to client personnel) or procedures performed after the year-end. To set detection risk lower, auditors would typically complete more testing at year-end, as compared to interim. The extent of the application of procedures usually refers to the sample sizes of data examined, such as the number of customer accounts receivable to confirm or the number of inventory types to count. To set detection risk lower, the auditor would typically increase sample sizes. 4.5

An auditor must always remember that a misstatement in the financial statements may be caused by an error or a fraud. The primary difference between a material misstatement due to fraud or due to error is intent. Specifically, did a manager or employee at the client intend to commit a fraud? Or, was the misstatement due to an error made by an employee or manager? The intent of the employee or manager is the absolute key.

4.6

According to the professional standards, an auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. As a direct result, an auditor is responsible for assessing the risk of material misstatement due to an error or fraud on every engagement. However, because of the damage to the capital markets caused by fraudsters who have intentionally misstated their financial statements, auditors must carefully assess fraud risk on every audit engagement. Once fraud risk has been assessed, the nature, timing and extent of audit work should change as a result of the auditor‘s fraud risk assessment. In general, the lower the risk of material misstatement due to fraud, the less persuasive the audit evidence needs to be. It therefore follows that when fraud risk factors are identified, the auditor generally must obtain more persuasive audit evidence. Most importantly, once fraud risk factors are identified, the auditor should clearly identify the fraud risks and then design and perform procedures that respond directly to fraud risks.

4.7

(a) White collar crimes are frauds perpetrated by people in a non-violent manner and are typically focused on stealing cash or assets. They are often committed by people who work in offices and steal items such as inventory, cash or other valuable assets. White collar crimes are often contrasted with violent street crimes like armed robbery, murder and kidnapping. (b) Employee fraud is the use of fraudulent means to take money or other property from an employer. It consists of three phases: (1) the fraudulent act, (2) the conversion of the money or property to the fraudster‘s use, and (3) the cover-up. (c) Embezzlement is a type of fraud involving employees or nonemployees wrongfully taking funds or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and cover-up.

(d) Larceny is simple theft of an employer‘s property that is not entrusted to an employee‘s care, custody or control. (e) Defalcation is another name for employee fraud and embezzlement. (f) Management fraud is deliberate fraud committed by management that injures investors and creditors through materially misstated information. Because management fraud usually takes the form of deceptive financial statements, management fraud is sometimes referred to as fraudulent financial reporting. AU 240 defines fraudulent financial reporting as ―intentional misstatements, including omissions of amounts or disclosures in financial statements to deceive financial statement users. It can be caused by the efforts of management to manage earnings in order to deceive financial statement users (g) Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. 4.8

There are three additional categories of fraud risk factors. Each of these categories features conditions that helped contribute to fraud in the past: Fraud Risk Factors - Management’s Characteristics and Influence          

Management has a motivation (bonus compensation, stock options, etc.) to engage in fraudulent reporting. Management decisions are dominated by an individual or a small group. Management fails to display an appropriate attitude about internal control and financial reporting. Managers’ attitudes are very aggressive toward financial reporting. Managers place too much emphasis on earnings projections. Nonfinancial management participates excessively in the selection of accounting principles or determination of estimates. The company has a high turnover of senior management. The company has a known history of violations. Managers and employees tend to be evasive when responding to auditors’ inquiries. Managers engage in frequent disputes with auditors.

Fraud Risk Factors – Industry Conditions     

Company profits lag those of the industry. New requirements are passed that could impair stability or profitability. The company’s market is saturated due to fierce competition. The company’s industry is declining. The company’s industry is changing rapidly.

Fraud Risk Factors –Operating Characteristics and Financial Stability 1-76 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

       

A weak internal control environment prevails. The company is not able to generate sufficient cash flows to ensure that it is a going concern. There is pressure to obtain capital. The company operates in a tax haven jurisdiction. The company has many difficult accounting measurement and presentation issues. The company has significant transactions or balances that are difficult to audit. The company has significant and unusual related-party transactions. Company accounting personnel are lax or are not experienced in performing their duties.

4.9

Inherent risk assessment helps to guide the auditor in allocating more and stronger resources to test specific accounts and disclosures that present a higher likelihood of material misstatement and therefore present a higher level of inherent risk. In effect, inherent risk assessment provides the basis for executing an appropriate response to the risks identified. The professional standards make clear that risk assessment underlies the entire audit process. When performing risk assessment procedures to accomplish this objective, the first step taken by auditors is often to assess inherent risk for each relevant assertion related to each of the significant accounts and disclosures identified on an audit engagement.

4.10

The nature of the company includes:

    

The company's organizational structure and management personnel. The sources of funding of the company's operations and investment activities The company's significant investments. The company's operating characteristics, including its size and complexity. The sources of the company's earnings, including the relative profitability of key products and services as well as key supplier and customer relationships.

4.11

The purpose of obtaining an understanding of the company's performance measures is to be able to determine what information management and others deem to be key indicators of company performance. It also reveals items to which management might be sensitive. For example, measures used to determine management compensation or analysts‘ ratings might place pressure on management to manipulate results. Also, auditors might gain a better understanding of their clients by reviewing measures that management uses to monitor operations, such as budget variances or trend analysis. Finally, those measures might be indicators of qualitative materiality factors.

4.12

Related parties include those individuals or organizations that can influence or be influenced by decisions of the company, possibly through family ties or investment relationships. Because one of the basic assumptions of historical cost accounting is that transactions are valued at prices agreed on by two independent parties, valuation of related-party transactions is particularly troublesome. Auditors also should question the persuasiveness of the evidence obtained from related parties because the source of the 1-77 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

evidence may be biased. Finally, related party transactions have been used by companies to perpetrate fraudulent transactions. Thus, auditors need to consider such transactions as higher risk of fraud. 4.13

The purpose of obtaining an understanding of the company‘s objectives, strategies, and related business risks is to identify business risks that could reasonably be expected to result in material misstatement of the financial statements. Of course the best starting point is with management whose job it is to be knowledgeable about the company‘s risks. In order to get understanding of a client‘s business and industry, an auditor can consider: 

Studying numerous sources such as AICPA industry accounting and auditing guides, specialized trade magazines and journals, registration statements and 10-K reports filed with the SEC, general business magazines and newspapers (Bloomberg Businessweek, Forbes, Fortune, Harvard Business Review, Barron’s, and The Wall street Journal).



Using inquiry of client personnel, including review of prior-year audit documentation (personnel who worked on the audit in prior years are available to convey their understanding of the business), inquiry, and interviews with the company‘s management, directors, and audit committee.



Using information from client acceptance and retention evaluation, audit planning, past audits, and other engagements.



Considering the results of the audit team discussions (brainstorming), this involves sharing information among members of the engagement team.

4.14

The purpose of performing preliminary analytical procedures in the audit planning stage is to direct attention to potential problem areas so the audit work can be planned to reduce the risk of missing something important. In fact, according to auditing standards, analytical procedures must be applied in the planning stages of each audit. During this critical point of the engagement, auditors use analytical procedures to identify potential problem areas so that subsequent audit work can be designed to reduce the risk of missing something important. Analytical procedures during planning also provide an organized approach—a standard starting place—for becoming familiar with the client‘s business. Auditors need to remember that preliminary analytical procedures are based on unaudited data, so they should consider the effectiveness of controls over their reliability when deciding how much weight to place on the results.

4.15

The five steps auditors use to apply comparison and ratio analysis to unaudited financial statements when completing preliminary analytical procedures are to: (1) develop an expectation, (2) define a significant difference, (3) calculate predictions and compare them with the recorded amount, (4) investigate significant differences, and (5) document each of the first four steps.

4.16

There are a number of ratios that can be used in completing preliminary analytical procedures. Some of the ratios that can be used include current ratio, days‘ sales in receivables, doubtful accounts ratio, days‘ sales in inventory, receivables turnover, inventory turnover, cost of goods sold ratio, return on equity, and Altman‘s financial distress ratios and discriminant score. There are a number of other ratios that can be used as well. In addition, depending on the industry of the client, there may be key performance metrics within that industry that might be useful to complete such procedures.

4.17

Analytical procedures are required (1) at the beginning of an audit—the planning stage by applying analytical procedures discussed in this chapter and (2) at the end of an audit when the partners in charge review the overall quality of the work and look for apparent problems. They are optional as substantive audit procedures since test of details can be used instead when gathering evidence about each relevant financial statement assertion about each significant account and disclosure.

4.18

Auditors are required to plan their procedures to detect material misstatements due to errors, fraud, and noncompliance with laws and regulations having a direct effect on financial statements. For laws and regulations having an indirect effect on financial statements, auditors are limited to performing specified audit procedures that may identify noncompliance with those laws and regulations that may have a material effect on the financial statements, inquiry of management and those charged with governance, and inspection of correspondence with relevant licensing or regulatory authorities. However, if auditors become aware of the possibility of indirect-effect noncompliance, they are required to follow up to ensure there is no material effect on the financial statements.

4.19

The audit strategy memorandum is the basis for preparing the detailed audit plans (often called ―audit programs‖) for each significant account and disclosure on the audit. The audit plans list the audit procedures to be performed by auditors to gather sufficient appropriate evidence on which to base their opinion on the financial statements. The audit strategy memorandum sets the scope, timing, and direction for auditing each relevant assertion. If the auditors identified fraud risk or significant risks of noncompliance with laws and regulations, these areas will be specifically addressed in the strategy, including the possibility of adding fraud specialists to the team or expanding testing.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 4.20

Incorrect.

Correct.

4.21

a. b. c. d.

Incorrect. Incorrect. Incorrect. Correct.

In credit sales and debit receivables, not inventory. In credit sales and debit receivables, not cost of goods sold. In credit sales and debit receivables, not bad debt expense. In (fictitious) credit sales and (fictitious) receivables.

4.22

Incorrect.

Correct.

Incorrect.

Falsification of documents is characteristic, but management fraud does not involve stealing funds from an employer. Management fraud is victimization of investors through the use of materially misleading financial statements. Management fraud principally involves misleading financial statements that might or might not involve illegal acts committed by management to evade laws and regulations. Conversion of stolen inventory to cash deposited in a falsified bank account describes an employee fraud.

Incorrect.

Correct.

Incorrect.

Correct.

4.23

4.24

Auditors are supposed to understand the nature of errors and frauds. Auditors are supposed to assess the risk of occurrence of errors and frauds. Auditors are supposed to design audits to provide reasonable assurance of detecting errors and frauds. Auditors are not required to report all finding of errors and frauds to police authorities.

Extended procedures would be used if supporting documents are not produced when requested. If the client made several large adjustments at year-end (a red flag), extended procedures would be considered necessary to ensure that fraud was not taking place. Unless the previous CFO left the company under suspicious circumstances, extended procedures would probably not be considered necessary. Due to the immateriality of petty cash funds, the audit team would probably not use extended procedures under these circumstances. Inherent risk is one component of the risk of material misstatement (the correct answer). Control risk is one component of the risk of material misstatement (the correct answer). Detection risk is the likelihood that the auditors will not detect misstatements that may have entered the accounting system and not been detected or corrected by the client‘s internal controls. This is the definition of the risk of material misstatement.

4.25

Correct.

Incorrect

b. c. d.

Incorrect Incorrect Correct

Audit risk also considers the risk of material misstatement as well as auditors‘ procedures. Inherent risk exists independently of the audit. Control risk exists independently of the audit. This is the definition of detection risk.

4.27

a. b. c. d.

Incorrect Correct. Incorrect Incorrect

DR = AR/ (IR x CR) = 0.05/0.50 = 0.10. DR = AR/ (IR x CR) = 0.05/0.50 = 0.10. DR = AR/ (IR x CR) = 0.05/0.50 = 0.10. DR = AR/ (IR x CR) = 0.05/0.50 = 0.10.

4.28

Incorrect

b. c. d.

Incorrect Correct Incorrect

While solving for DR works mathematically, you will find that IR (not given in the problem) has to be more than 100%; therefore, the solution is not possible. (Very tricky!) If control risk rises, detection risk should decrease. This solution is both mathematically and practically correct. If control risk rises, detection risk should decrease.

Incorrect.

Correct.

Incorrect.

a. b. c.

Incorrect. Incorrect. Correct.

Incorrect.

4.26

4.29

4.30

The risk of material misstatement is composed of inherent risk and control risk. The risk of material misstatement is composed of inherent risk and control risk. The risk of material misstatement is composed of inherent risk and control risk. The risk of material misstatement is composed of inherent risk and control risk.

This is a type of ―overall response,‖ not a ―specific procedural response.‖ Auditors ought to direct specific procedures toward the area where the suspicion lies. This is a specific procedural response mentioned in audit standards. This is an overall response, not a ―specific procedural response.‖ Confirmation is not an analytical procedure. Physical observation is not an analytical procedure. Analytical procedures incorporate information from a variety of sources. Examination of documents is not an analytical procedure.

4.31

4.32

4.33

4.34

Incorrect.

Correct.

Incorrect.

Correct.

Incorrect.

Correct.

a. b.

Incorrect. Correct.

c. d.

Incorrect. Incorrect

Physical production statistics are not a source of information for ―comparison of current account balances with prior periods.‖ A client‘s budgets and forecasts are sources of information for ―comparison of current account balances with expected balances.‖ Published industry ratios are not a source of information for ―evaluation of current account balances with relation to predictable historical patterns.‖ The company‘s own historical financial statements are not a good source of information for ―evaluation of current account balances in relation to nonfinancial information.‖ Analytical procedures can be used as a method of overall review at the end of an audit. In fact, this is required by professional standards. Analytical procedures can be used when directing the attention of auditors to certain accounts and disclosures when planning the audit. In fact, this is required by professional standards. Analytical procedures can be used when performing substantive procedures during an audit. The other choice is tests of details. It is entirely up to the auditor which tests are used based on the facts, circumstances, and risk of the assertion and the account or disclosure. The answer is all of the above. Analytical procedures can be used when planning the audit, when performing substantive procedures during an audit, and as a method of overall review at the end of an audit. Weaknesses in the company‘s internal control are not a subject for preliminary analytical procedures because auditors can‘t examine the internal controls at this particular time with these kinds of analyses. Individual transactions are not used in preliminary analytical procedures. Management assertions in financial statements are not the direct object of preliminary attention-directing analytical procedures. With preliminary analytical procedures, the auditors are looking for signs of accounts and relationships that may represent specific potential problems and risks in the financial statements. The ratio of cost/sales does not increase. The numerator (cost of goods sold) increases relatively less than the denominator (sales) increases. The ratio of cost/sales does not remain unchanged. See answer b.

4.35

Correct.

b. c.

Incorrect. Incorrect.

Incorrect.

Correct.

Incorrect.

An audit strategy does not specify audit standards. The standards are relevant in all audits. An audit strategy contains specifications of procedures the auditors believe appropriate for the financial statements under audit. Documentation of the assertions under audit, the evidence obtained, and the conclusions reached describe audit documentation, not audit strategies. Reconciliation is a specific procedure, not a strategy.

4.37

a. b. c. d.

Correct. Incorrect. Incorrect. Incorrect.

The objective is to perform a quality audit and keep audit risk low. Control risk = 0 is generally not warranted. Inherent risk = 0 is generally not warranted. 40% audit risk is too high.

4.38

Incorrect.

Correct.

Incorrect.

Reporting clearly inconsequential noncompliance with the Act to the board of directors is not required. Once informed, the board of directors has the first responsibility to report to the SEC. If the board does not report these items to the SEC, the law then requires the auditors to do so. Auditors are not required to report clearly inconsequential noncompliance with the Act to the board. (Reporting to management, however, is appropriate.) Audit firm resignation is not required. However, if the audit firm withdraws and the board does not report the item to the SEC, the law requires the auditors to report to the SEC, just as though there had been no resignation.

Incorrect.

Correct.

4.36

4.39

Management is responsible for making the estimates in the first place, just as management is primarily responsible for all the financial statement elements. Auditors need to determine the reasonableness of estimates. Auditors need to determine estimates are presented in conformity with GAAP. Auditors need to determine whether estimates are adequately disclosed in the financial statements.

4.40

4.41

4.42

4.43

Incorrect

Correct.

Incorrect

Incorrect.

Correct.

Incorrect.

Correct.

Incorrect.

b. c.

Correct. Incorrect.

Incorrect.

An audit committee is composed of members of a company‘s board of directors who are not involved in the day-to-day operations of the company. An audit committee is composed of members of a company‘s board of directors who are not involved in the day-to-day operations of the company. An audit committee is composed of members of a company‘s board of directors who are not involved in the day-to-day operations of the company. An audit committee is composed of members of a company‘s board of directors who are not involved in the day-to-day operations of the company. While the audit team may recommend remedial actions to the audit committee, the audit team‘s first concern is the effect of the noncompliance on the financial statements. The audit team‘s first concern is the effect of the noncompliance on the financial statements. While the audit team may consider whether to contact law enforcement officials, the audit team‘s first concern is the effect of the noncompliance on the financial statements. While the audit team should determine whether other similar acts may have occurred, the audit team‘s first concern is the effect of the noncompliance on the financial statements. The responsibility for detecting direct-effect noncompliance exactly parallels the responsibility for errors and fraud. The audit team must design their tests to detect all material noncompliance that directly affect the financial statements. Auditors must design tests to obtain reasonable assurance that all noncompliance with direct material financial statement effects is detected. The audit team must design their tests to detect all material noncompliance that directly affect the financial statements. Analytical procedures are performed after the engagement letter is obtained. This is the ―attention-directing‖ purpose. Significant assertions are determined by understanding the company, not by analytical procedures. This answer could be good even though it evokes the control risk assessment standard, but restriction to inventory makes it a poor choice.

4.44

4.45

4.46

4.47

a. b. c.

Incorrect. Incorrect. Incorrect.

Correct.

Incorrect.

Correct.

Incorrect.

Correct.

Incorrect.

This is an objective of a preliminary analytical review. This is an objective for tests of details. This is an objective for fraud procedures that are targeted to mitigate the risk of fraud in the financial statements. This is the correct answer. At the final review stage, analytical review procedures are designed to provide an overall test of reasonableness about the financial statements being reviewed, in light of all available evidence. This is the correct answer. An error in recording amortization of the excess of the investor‘s cost over the investment‘s underlying book value could have been the cause of a lower than expected return on an equity method investment. This is not the correct answer. A reduction in cash dividends made by the investee could not have been the cause of a lower than expected return on an equity method investment. This is not the correct answer. An error in recording the unrealized gain from an increase in fair value of available-for-sale investments could not have been the cause of a lower than expected return on an equity method investment. This is not the correct answer. A significant fluctuation in the price of an investee‘s stock price would not have been the cause of a lower than expected return on an equity method investment. The performance of substantive audit testing, whether substantive analytical auto procedures or tests of details, would not increase or decrease inherent risk. The performance of substantive audit testing, whether substantive analytical procedures or tests of details, would not increase or decrease control risk. The decision to perform substantive analytical procedures (as compared to a test of details) at interim (as compared to the balance sheet date) would increase detection risk. Sampling is typically not performed when completing substantive analytical procedures. Thus, there would be no impact on sampling risk. The fiscal year end date is not likely to have an impact on the auditor‘s inherent risk assessment. By their very nature, derivative transactions are designed to be used as hedges for exposure on existing contracts are quite complex. The accounting rules that provide the basis for GAAP in this area are also complex. As a result of this complexity, the inherent risk of material misstatement is higher. The generation of financial statements at an outside service center may be a concern to the auditor. However, it is primarily a factor that would relate to the auditor‘s control risk assessment.

4.48

Incorrect.

The observation that the entity‘s financial data is only available in computer-readable form is likely to be a concern for the auditor. However, it is primarily a factor that would relate to the auditor‘s control risk assessment.

Incorrect.

Correct.

Incorrect.

The fraud brainstorming session is primarily focused on fraud risk assessment, which is the potential for material misstatement due to fraud in the financial statements. While information may come to light during the session that relates to audit risk assessment and/or materiality determination, it is not the primary objective of the session, according to professional standards (i.e., SAS No. 99). The fraud brainstorming session is primarily focused on fraud risk assessment, which is the potential for material misstatement due to fraud in the financial statements. While information may come to light during the session that relates to the application of analytical procedures on the revenue account, it is not the primary objective of the session, according to professional standards (i.e., SAS No. 99). The fraud brainstorming session is primarily focused on fraud risk assessment, which is the potential for material misstatement due to fraud in the financial statements. This is the primary objective of the session, according to professional standards (i.e., SAS No. 99). The fraud brainstorming session is primarily focused on fraud risk assessment, which is the potential for material misstatement due to fraud in the financial statements. While information may come to light during the session that relates to the audit plan, this is not the primary objective of the session, according to professional standards (i.e., SAS No. 99).

SOLUTIONS FOR EXERCISES AND PROBLEMS 4.49 Analytical Procedures and Interest Expense a.

The audit estimate of interest expense for these notes is about $24,400. Notes Payable Balances Auditors‘ Interest Calculation Date Balance Rate Jan 1 $150,000 10.0% Feb 1 $200,000 10.0% Mar 1 $200,000 10.0% Apr 1 $225,000 10.0% May 1 $285,000 10.0% Jun 1 $375,000 10.0% Jul 1 $375,000 9.5% Aug 1 $430,000 9.5% Sep 1 $290,000 9.5% Oct 1 $210,000 9.5% Nov 1 $172,000 9.5% Dec 1 $95,000 9.5%

Weighted Average $250,583

Time 1 month 1 month 1 month 1 month 1 month 1 month 1 month 1 month 1 month 1 month 1 month 1 month

9.75% 12 months

Calculated on Average Balance and Average Rate

1 1 1 1 1 1 1 1 1 1 1 1

Interest $1,250 $1,667 $1,667 $1,875 $2,375 $3,125 $2,969 $3,404 $2,296 $1,663 $1,362 $752

12 $24,405 $24,432

The type of analytical procedure is ―study of the relationships of current-year account balances with relevant nonfinancial information.‖ While the interest rate may not seem to be an item of ―nonfinancial information,‖ it is not a direct entry or element in the client‘s financial statements. Three of the other four types of analytical procedures do not describe the estimate (because it does not compare to prior periods, to budget, or to industry information). However, a case might be made that the estimate is an ―evaluation of a relationship of current-year account balances (notes payable) to other current-year balances (related interest expense) for conformity with a predictable pattern (interest rate relation) based on the company‘s experience.

The recorded interest expense appears to be too small. The company may have forgotten or miscalculated the year-end interest expense accrual. (In fact, this amount was specified because the missing amount is approximately the $750 of the accrual for the December interest.)

The recorded interest expense is about right. Some differences in timing and calculation might explain the small difference, but it is not material enough to warrant further work.

The recorded interest expense appears to be too large. Maybe the company has other debt on which interest is being paid, but the debt is not recorded in the accounts. (In fact this amount was specified in terms of an extra $100,000 being borrowed in July at 9.5% interest, not recorded, but paid back by August 1 before the next recorded borrowing. This would account for about $800 additional interest: $100,000 x 9.5% x 1/12 = $792.) Could be that Weyman found he could borrow the company‘s cash for himself, earn interest, and then pay back the principal!) Actually, this kind of maneuver could have been carried out in any month and not noticed by auditors who saw only the first-of-the-month balances.

4.50 Appropriateness of Evidence and Related Parties a.

Yes, there are problems. Verbal assurance of collectability from Bumpus, the S&L officer with an investment in the Smith Street property, is the weakest type of information. Bumpus is a related party and information from him ought to be regarded as biased. Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc., the appraisers may be related, even owned by, the client, Guaranteed Savings & Loan Company. The audit team‘s general knowledge of financial institution difficulties in real estate lending and the widespread problems with appraisers should alert them to the possible relation of the appraisers to the client. Further investigation should be carried out to identify the appraisers.

Do you perceive any problems with M. Johnson‘s reasoning or the appropriateness of evidence used in that reasoning? Yes, there are problems. In addition to the dubious related-party sources of information just mentioned, Johnson‘s ―assumption‖ about the collectability of the Baker Street loan is unwarranted. Auditors are not entitled to ―assume‖ collectability on any grounds with supporting evidence. The fact that a loan is new or construction is still in progress is no reason to ―assume‖ collectability.

4.51

Risk of Misstatement in Various Accounts a.

Asset and revenue accounts are most likely to be overstated as the overstatement in order for management to increase net income. However, there are exceptions. Inventory understatements may occur from counting and pricing errors. Fixed asset understatements may result from failure to capitalize costs (expensing them instead) or from erroneous depreciation calculations. Liability understatement and expense understatement appear to be quite common, as these misstatements result in improved perceptions of financial condition and profitability.

4.52

A company might be motivated by tax evasion to understated assets. Asset understatements can result from accounting errors, misapplication of accounting principles, and measurement errors (such as undercounting the inventory).

The company might allow liability accounts to be overstated in order to reduce taxable income. Estimated liabilities might be measured as too large for conservatism. A fraud might be imbedded in false payables to false vendors.

The data indicate that income overstatement occurs most frequently. Apparently the cause is usually understatement of expenses (e.g. accrued expenses) or overstatement of revenues.

Analysis of Accounting Estimates The company has fudged the write-offs as being as small as possible, hoping to satisfy the auditors. Taken one at a time, only the uncertainty about the deferred subscription costs is large enough to break the materiality threshold. But the set of problems cannot be taken one at a time. Here is a suggested low-high audit estimate:

Write-off deferred subscription costs (1) Provide allowance for bad debts (2) Provide for expected warranty expense (3) Lower of cost or market inventory write-down (4) Loss on government contract refund (5) Total write-offs and losses

Low Estimate $ 6,000,000 $ 4,000,000 $ 2,000,000

High Estimate $12,000,000 $ 4,000,000 $ 6,000,000

$ 5,600,000 $ 1,000,000

$ 5,600,000 $ 2,000,000

$18,600,000

$29,600,000

(1)

The low estimate gives the benefit of doubt to the survival of the business, writing off half the deferred costs as if one-half might be written off over the next two years. The company seems to have taken the 50% probability ($6 million) and allocated half to each of the two years.

(2)

The company seems ready to provide the allowance for all the doubtful accounts receivable.

(3)

There is not much information for the audit team (such as a probability distribution).

(4)

It appears that the company plans to rebuild the inventory and recover as much as it can, namely the $4,400,000 that can be realized from selling the rebuilt parts, but the lower of cost or market was figured incorrectly. The company seems to have subtracted the selling price ($8 million) from the inventory cost ($10 million) to get the $2 million write-down. The correct calculation is: Net realizable value Selling price proceeds $ 8,000,000 Cost to rebuild $(2,000,000) Cost to market and ship (20% x $8 million) $ (1,600,000) Ceiling (net realizable value) $ 4,400,000 Floor; subtract ―normal profit‖ (5% x $8 million) $ (400,000) Floor $ 4,000,000 Replacement cost is apparently $6 million for the modern part, so the ―market‖ for lower of cost or market is NRV = $4,400,000, and the inventory write-down is $10,000,000 – $4,400,000 = $5,600,000. Sale of the rebuilt parts will produce zero profit in subsequent period(s): Selling price $ 8,000,000 Cost of goods sold Inventory sold (written-down cost) 4,400,000 Rebuilding cost 2,000,000 $(6,400,000) Cost to market and ship ($1,600,000) Profit $ 0

(5)

For a contingency such as this government contract dispute, GAAP suggests recognizing loss at the lower end of a range for loss, so a $1 million loss provision would satisfy GAAP.

Recommended adjustment: Management‘s suggestion of $11,000,000 cost/loss recognition is not sufficient. It ―leaves‖ $7,600,000 income overstatement, even using the auditors‘ low estimate of $18,600,000. Even booking the low estimate ―leaves‖ $10,000,000 unrecognized (including the government contract contingency at $1 million instead of $2 million). The minimum adjustment, given the limited information available in this problem, follows. Adequate disclosures should be made about the $6 million deferred subscription costs remaining and the prospects for the business as well as about the warranty expense estimate because these are the items that leave uncertain assets and liabilities in the financial statements.

Subscription expense Bad debt expense Warranty expense Cost of goods sold Government contract loss Deferred subscription costs Allowance for doubtful accounts Estimated warranty liability Inventory Estimated liability on contract

4.53

Debit $ 6,000,000 $ 4,000,000 $ 2,000,000 $ 5,600,000 $ 1,000,000

Credit

$ 6,000,000 $ 4,000,000 $ 2,000,000 $ 5,600,000 $ 1,000,000

Horizontal and Vertical Analysis TO: FROM: DATE: SUBJECT:

Current Working Paper File Auditor Retail Company Audit—Preliminary Analytical Review

Revenue and Current Ratio Sales decreased 10%, and the company may be tempted to misstate accounts in order to avoid reporting an income decrease. The requirement to maintain a 2:1 current ratio presents temptation to overstate current asset accounts and understate current liability accounts.

Sales, Sales Returns, and Accounts Receivable Both sales and accounts receivable are down. The days‘ sales in receivables and receivables turnover ratios confirm the relative decrease. The allowance for doubtful accounts ratio is approximately in line with that of last year. Even though the sales decline might tempt people to record invalid sales, there is not much room to hide them in accounts receivable. If the allowance for doubtful accounts should be 8%, as last year, the allowance should be $32,000, indicating a $2,000 understatement in the allowance and $2,000 overstatement of net realizable value of accounts receivable. Inventory and Cost of Goods Sold Cost of goods sold as a percent of sales is down from 70 percent to about 65 percent. If 70 percent is more accurate, cost of goods sold might be understated by $405,000, or almost 76 percent of the $530,000 operating income (before taxes, interest expense, and other revenue and expense). The related inventory accounts may therefore be overstated, perhaps as much as $405,000. The trial balance shows that inventory increased $440,000 (29 percent). The days‘ sales in inventory and inventory turnover ratios confirm the relative increase of inventory dollars. We should audit the physical inventory and inventory pricing carefully. Accruals and Expenses The depreciation expense is the same as last year, but $1,000,000 new assets are in the Equipment account. We need to recalculate depreciation expense. Either the company forgot to record depreciation on new assets, the assets are fictitious and have not been put on the depreciation schedule, or the assets were acquired so late in the year that fractional depreciation is immaterial. Interest expense on the new bank loan appears not to have been paid or accrued. The interest expense in the trial balance seems to be interest on the long-term debt at 10 percent. According to the problem information, interest since July 1 at 11% on $750,000 (expense = $41,250) should have been recorded. Other accruals are smaller than last year, and general expenses are only slightly lower. Maybe some accrued expenses did not get recorded. We need to be sure to conduct the search for unrecorded liabilities and expenses. If the ratio of accruals to expense for last year (0.03) is relevant for this year, the accruals should be about $60,000 instead of $10,000. Liabilities It appears that there was an error in the prior-year audited financial statements; $100,000 of the long-term debt should have been classified as ―current portion of long-term debt.‖ None is classified as a current liability in the current-year unaudited financial statements.

Retained Earnings We were told that no dividends have been declared or paid, but the ending retained earnings is not equal to the beginning retained earnings plus net income. There is a $100,000 discrepancy that could be dividends, a prior-period adjustment, or a loss improperly debited to retained earnings. Maybe the books just do not balance! A constructed cash flow statement (attached) shows an unexplained $100,000 cash ―shortage.‖ Maybe a loss or expense was debited directly to retained earnings. Going-Concern Consideration The company appears to have used operating cash flow and new bank loans ($750,000) to finance asset purchases ($1,000,000) and long-term debt repayment ($100,000). Current liabilities increased much more than current assets (inventory increase), and the current ratio declined from 4.57 to 2.00. Likewise the total debt to equity ratio increased from .35 to .56 Overstatement of the inventory, omission of accrued expenses, and misclassification of the current portion of long-term debt would cause the current ratio to be 2:1, exactly as required by the loan agreement, instead of less than 2:1. The existence of the loan agreement requirement makes the risk of misstatement higher under these conditions. While the company does not seem to be in dire financial straits, we ought to review the cash flow budget for next year. Retail Company Cash Flow Statement Operations: Net income Depreciation Decrease net accounts receivable Increase inventory Increase accounts payable Decrease accruals Cash flow from Operations Investing activities Additions to fixed assets

$ 294,000 300,000 90,000 (440,000) 150,000 ( 60,000) $ 334,000

( 1,000,000)

Financing activities New loan acquisition Debt repayment Financing cash flow Net cash increase Beginning cash balance Ending cash balance Reported cash balance

$ 750,000 ( 100,000) 650,000 $ ( 16,000) 600,000 $ 584,000 484,000

Unexplained cash Difference

Reported (unaudited) Added bad debt allowance Overstated inventory Interest accrual Expense accrual Depreciation expense Unidentified RE debit Reclassify long-term debt Income tax reduction* Adjusted

$ 100,000

Retail Company Summary of Potential Problems Current Current Income Assets Liabilities $ 294,000 $ 2,794,000 $ 1,400,000 ( 2,000) ( 2,000) ( 405,000) ( 405,000) ( 41,250) 41,250 ( 50,000) 50,000 (100,000) (100,000) 100,000 279,300 279,300 _________ $(124,950) $ 2,666,300 $1,591,250

Adjusted current ratio = 1.68:1 *Refund of taxes paid plus refund from tax loss carryback. 4.54

Analysis and Judgment This problem is one of Robert Ashton‘s cases on judgment and decision making (Accounting Review, January 1984, pp. 78–97.) Ashton gives credit to Joyce and Biddle, ―Anchoring and Adjustment in Probabilistic Inference in Auditing,‖ Journal of Accounting Research, Spring 1981, p.1 The case is set up to illustrate a person‘s tendency to anchor an estimate on some known information and adjust from that point in the course of performing analysis. This particular case setup is intended to illustrate conjunctive and disjunctive events. Ashton‘s ―answer key‖ explains in this manner: Ashton’s Answer Key (abridged) This exercise focuses on probability estimates for two types of complex events called ―conjunctive‖ and ―disjunctive.‖ The occurrence of a conjunctive event depends on the joint occurrence of all of a number of subevents, each with a given probability of occurrence. 1-94 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

An example is getting three 3‘s in a row when rolling a die. This is a conjunctive event with probability of 1/6 raised to the third power (1/6 x 1/6 x 1/6), or about 0.005. An example of a disjunctive event is getting at least one of a number of subevents, such as one 3 in three rolls of the die. The probability of this disjunctive event is about 0.42. If you are asked to estimate the probabilities of the conjunctive and disjunctive events of rolling the die, a natural starting place (anchor) would be to know that the probability of getting one 3 in one roll is 1/6, or 0.167. Then to estimate the more difficult conjunctive event (three 3‘s in a row), a downward adjustment would be required. Conversely, for the disjunctive event (one 3 in three rolls), an upward adjustment would be needed. However, because adjustments from an anchor are usually insufficient, the estimated probability of the conjunctive event will likely be too large and that of the disjunctive event too small. Form A of the problem (the one in the textbook chapter) is a conjunctive statement of the problem, and it asks for an estimate of the probability of successful product introduction. With the five subevents considered independent of each other, the best answer is 0.554 (.80 x .90 x .95 x .90 x .90). Students may anchor on the probabilities of the elementary subevents and fail to adjust sufficiently downward, and their probability estimates will be higher than 0.554. Form B of the problem (reproduced on the next page, not in the textbook) is a disjunctive statement of the same problem, and the best answer is still 0.554. Form B, however, is stated in terms of failure in the chain of events. (Student responses must be subtracted from 1.000 to make them comparable to Form A.) If students anchor on the probabilities of the elementary disjunctive subevents in Form B, their probability estimates (subtracted from 1.000) will probably be too low. NOTE TO INSTRUCTOR: You may want to reproduce Form B and give both the textbook problem (conjunctive) and the Form B alternative (disjunctive) to different groups of students to illustrate the anchoring and adjustment behavioral phenomenon. You may also want to give students a response scale to make your classroom discussion easier. Ask them to circle one: .00 .10 .20 .30 .40 .50 .60 .70 .80 .90 1.00 FORM B Analysis and Judgment As part of your regular year-end audit of a publicly held client, you must make an estimate of the probability of success of its proposed new product line. The client has experienced financial difficulty during the last few years and—in your judgment—a successful introduction of the new product line is necessary for the client to remain a going concern. 1-95 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Any one of the following occurrences will prevent successful introduction of the new product line: (1) unsuccessful labor negotiations between the construction firms contracted to build the necessary addition to the present plant and the building trade unions, (2) unsuccessful defense of patent rights, (3) failure to obtain product approval by the FDA, (4) failure to successfully negotiate a long-term raw materials contract with a foreign supplier, and (5) failure to successfully conclude distribution contract talks with a large national retail distributor. In view of the circumstances, you contact experts who have provided your audit firm reliable estimates in the past. The labor relations expert estimates that there is a 20% chance that labor negotiations will not be successfully resolved before the strike deadline. Legal counsel advises that there is a 10 percent chance that the patent rights defense will not be successful. The expert on FDA product approvals estimates the probability of failing to obtain approval at 5%. The experts in the two remaining areas estimate the probabilities of failing to resolve (a) the raw materials contract and (b) the distribution contract talks to be 10% in each case. Assume these estimates are reliable. 4.55

Analytical Procedures Majestic appears to be a large hotel: 1. Has 200 rooms versus 148 2. That charges slightly more than the average rate ($160 versus $120) 3. and does not promote room occupancy too heavily (2.7% advertising versus 3.2%) 4. Hence, its occupancy—paying guests—is not especially high (62.6% versus 68.1%), although this occupancy rate represents more average rooms per day (125 = 62.6% x 200) than the industry (101 = 68.1% x 148) Majestic also appears to: 1. Derive relatively more revenue from food and beverages (35.7%) than the industry (32.3%) 2. Be more lavish in providing food and beverages  Cost of food sold (42.1% versus 37.0%)  Cost of beverages sold (43.6% versus 29.5%)  Service—wages (39.6% versus 32.8%) Memorandum—good working paper style Index AP 7

Prepared by ____JR____ Date____5/15/21

Majestic Hotel Preliminary Plan Memorandum Analysis of Statistics FYE 3/31/2021 Analysis of the operating statistics in working paper AP-6 indicates that the following may be indicative of areas in the accounts where potential errors or frauds or other matters of audit concern may exist. These should be covered in our preliminary planning of the audit plan. 1.

Room sales revenue is not up to the industry average ratio. Revenues may not be recorded properly—either not recorded or misclassified as food and beverage sales.

Management fees appear considerably higher than the industry average. Expenses may be misclassified or a related-party transaction may be involved.

Utilities, repairs, and maintenance appear to be higher than the industry average. Some capitalizable expenditures may have been improperly classified as current expenses.

Salaries and wages in both the rooms department and the food and beverages department appear to be high. The problem may be more employees than average, padded payrolls, or wage rates higher than average.

The cost of food and beverages sold appears to be much higher than the industry average. This could be due to payment of higher unit prices (presumably for higher quality), use of larger quantities per serving, inventory pilferage, or erroneous inventory counts and pricing.

4.56

Preliminary Analytical Procedures DUNDER MIFFLIN, INC. PRELIMINARY ANALYTICAL PROCEDURES DATA COMPARATIVE, COMMONSIZE FINANCIAL STATEMENTS Prior Year (Audited)

Current Year (Unaudited)

Change

Balance

Common Size

Balance

Common Size

Percent Change

Amount

Sales (net)

$9,000,000

100.00%

$9,720,000

100.00%

$ 720,000

8.00%

Cost of goods sold

6,296,000

69.96

7,000,000

72.02

704,000

11.18

Gross margin

2,704,000

30.04%

2,720,000

27.98%

16,000

0.59%

General expense

2,044,000

22.71

$2,003,000

20.61

(41,000)

–2.01

Revenue and expense:

Depreciation Operating income Interest expense Income taxes (40%) Net income Assets: Cash Accounts receivable Allowance doubtful accounts Inventory Total current assets Fixed assets Accum depreciation Total assets Liabilities and equity: Accounts payable Bank loans, 8% Accrued interest Accruals and other Total current liabilities Long-term debt, 10% Total liabilities Capital stock Retained earnings Total liabilities and equity

300,000 $360,000 60,000 120,000 $180,000

3.33 4.00% 0.67 1.33 2.00%

334,000 $383,000 75,000 123,200 $184,800

3.44 3.94% 0.77 1.27 1.90%

34,000 $23,000 15,000 3,200 $4,800

11.33 6.39% 25.00 2.67 2.67%

$600,000 500,000

14.78% 12.32

690,800 900,000

12.52% 16.31

90,800 400,000

15.13% 80.00

(40,000) 1,500,000 $2,560,000 3,000,000 (1,500,000) $4,060,000

–0.99 36.95 63.05% 73.89 –36.95 100.00%

(90,000) 1,350,000 $2,850,800 4,500,000 (1,834,000) $5,516,800

–1.63 24.47 51.67% 81.57 –33.24 100.00%

(50,000) (150,000) $290,800 1,500,000 (334,000) $1,456,800

125.00 –10.00 11.36% 50.00 22.27 35.88%

$450,000 0 60,000 50,000 $560,000

11.08% 0.00 1.48 1.23 13.79%

$330,000 1,750,000 40,000 32,000 $2,152,000

5.98% 31.72 0.73 0.58 39.01%

($120,000) 1,750,000 (20,000) (18,000) $1,592,000

–26.67%

600,000 $1,160,000 2,000,000 900,000 $4,060,000

14.78 28.57% 49.26 22.17 100.00%

400,000 $2,552,000 2,000,000 964,800 $5,516,800

7.25 46.26% 36.25 17.49 100.00%

(200,000) $1,392,000

–33.33 120.00% 0.00 7.20 35.88%

64,800 $1,456,800

–33.33 –36.00 284.29%

DUNDER MIFFLIN, INC. SELECTED FINANCIAL RATIOS Current Prior Year Year 4.57 1.32 18.40 30.00 0.0800 0.1000 85.77 69.43 0.40 0.86

Percent Change –71.02% 63.04% 25.00% –19.05% 115.19%

19.57 4.20 69.96% 30.04% 6.34%

12.00 5.19 72.02% 27.98% 6.37%

–38.67% 23.54% 2.95% –6.86% –3.71%

0.49 0.22 0.09 2.59 2.22 4.96 $3,000,000

0.13 0.17 0.07 1.18 1.76 3.09 $3,000,000

–74.29% –21.11% –21.70% –54.55% –20.52% –37.67%

Balance Sheet Ratios Current ratio Days‘ sales in receivables Doubtful accounts ratio Days‘ sales in inventory Debt/equity ratio Operations Ratios Receivables turnover Inventory turnover Cost of goods sold/sales Gross margin % Return on beginning equity Financial Distress Ratios (Altman) Working capital/Total assets Retained earnings/Total assets EBIT/Total assets Market value equity/Total debt Net sales/Total assets Discriminant Z Score Market value of equity

Current (Unaudited)

Potential Error

Current as Affected (?)

Revenue and expense: Sales (net) Cost of goods sold

$9,720,000 7,000,000

($300,000) ( 216,000)

$ 9,420,000 6,784,000

Gross margin General expense Depreciation

$2,720,000 2,003,000 334,000

($ 84,000) 18,000 ( 4,000)

$2,636,000 2,021,000 330,000

Operating income Interest expense Income taxes (40%)

$ 383,000 75,000 123,200

($ 98,000) 35,000 ( 53,200)

$ 285,000 110,000 70,000

Net income

$ 184,800

($ 79,800)

$ 105,000

Assets: Cash Accounts receivable Allowance doubtful accounts Inventory Tax receivable

$ 690,800 900,000 (90,000) 1,350,000

$ 0 ( 300,000) 0 216,000 53,200

$ 690,800 600,000 (90,000) 1,566,000 53,200

Total current assets Fixed assets Accumulated depreciation

$2,850,000 4,500,000 (1,834,000)

($ 30,800) 0 4,000

$2,820,000 4,500,000 (1,830,000)

Total assets

$5,516,800

($ 26,800)

$5,490,000

Liabilities and equity: Accounts payable Bank loans, 8% Accrued interest Accruals and other

$ 330,000 1,750,000 40,000 32,000

0 0 35,000 18,000

$ 330,000 1,750,000 75,000 50,000

Total current liabilities Long-term debt, 10%

$2,152,000 400,000

$ 53,000 0

$2,205,000 400,000

Total liabilities Capital stock Retained earnings

$2,552,000 2,000,000 964,800

$ 53,000 0 (79,800)

$2,605,000 2,000,000 885,000

Total liabilities & equity

$5,516,800

($ 26,800)

$5,490,000

Solution explanation: Many of the conclusions are based on the prior year being the best indicator of currentyear ―accurate‖ figures. 1.

Sales and accounts receivable may be overstated by $300,000. Dunder Mifflin, Inc.‘s ―more liberal return privileges‖ may have caused early recording of sales and receivables. A $300,000 error will bring the accounts receivable back near the prior-year gross total.

If $300,000 of sales were recorded too early, the related Cost of Goods Sold should be restored to Inventory. Apparently the COGS is 72% of sales. The adjustment could be $216,000. However, if the proper COGS ratio is approximately 70% as in the prior year instead of 72%, the COGS may be overstated (and the inventory understated) by another $188,400 (2% x $9,420,000).

The Allowance for Bad Debts may need to be higher than in the prior year because of credit and return terms. Leave it at $90,000 on $600,000 receivables, although this 15 percent ratio is much higher than in the prior year (8%). However, if 8% is the more appropriate ratio, the allowance (and bad debt expense) may be overstated by $42,000 (7% x $600,000).

Expense accruals might have been omitted in the amount of $18,000, which would bring the accrued expenses up to the prior-year amount ($50,000).

Depreciation expense appears to have been calculated on the basis of the planned capital addition of $1,700,000 instead of the actual recorded amount of $1,500,000. ($1,500,000 for 25 years, 1/2 year, no salvage is $30,000 in addition to the prior-year $300,000.)

The bank loan interest accrual for the 4th quarter ($35,000 = $1,750,000 x .08 x 1/4 year) appears to have been overlooked. Interest expense for the six months should be $70,000 ($1,750,000 x .08 x 1/2 year) plus the $40,000 on the longterm debt for a total of $110,000 instead of $75,000.

The income-reducing potential errors have a tax effect (40%) of $53,200. Because Dunder Mifflin, Inc. apparently paid the taxes based on the unaudited income, a tax refund receivable will arise with the final tax return.

Although the problem information is not explicit, Dunder Mifflin, Inc. apparently paid dividends of $120,000 (same as prior year). If this is not the case, a $120,000 unexplained debit is buried in the retained earnings account. If it is not a dividend, it might be a misclassified loss or a prior period adjustment. 4.57

Audit Risk Model Evaluation of risk assessment conclusions with AR = IR x CR x DR as a model. 1. Paul is not justified in acting on a belief that IR = 0. He may have seen no adjustments proposed because (1) none were material or (2) Tordik‘s control system has functioned well in the past and prevented or detected and corrected material errors. If IR = 0, then AR = 0, and no further audit work need be done. Conservative auditing standards and practice do not permit this level of (non)work based on this little evidence and knowledge. 2. Hill is not justified in acting upon a belief that CR = 0. She may well know that Edward‘s internal accounting control is exceptionally good, but (1) her review did not cover the last month of Edward‘s fiscal year and (2) control activities are always subject to lapses. If CR = 0, then AR = 0, and no further audit work need be done. Conservative audit practice does not permit assessment of control risk at 0% to the exclusion of other audit procedures.

3. Insofar as audit effectiveness is concerned, Fields‘ decision is within the spirit of audit standards. Even if IR = 1 and CR = 1, if DR = 0.02, the AR = 0.02. This audit risk (AR) seems quite small. However, Fields‘ decision may result in an inefficient audit.

4. This case was deliberately left ambiguous without quantifying the audit risks. Students will need to experiment with the model. One approach is to compare the current audit to a hypothetical last year‘s audit when ―everything was operating smoothly.‖ Assume: Last year: Current year:

AR = IR (0.50) + CR (0.20) x DR (0.20) = 0.02 AR = IR (1.0) + CR (1.0) x DR (0.25) = 0.25

Features of the hypothetical comparison: (1) Inherent risk is greater than last year. (2) Control risk is greater than last year. (3) The audit was less extensive, possibly resulting in more detection risk. (4) Audit risk appears to be very high. An alternative analysis is that Shad perceived higher inherent and control risk early, and he did not put any audit time into trying to assess the risks at less than 100%. He proceeded directly to performance of extensive substantive procedures and worked fewer total number of hours yet still performed a high-quality audit by keeping AR low by keeping DR low. 4.58

Auditing an Accounting Estimate The audit problem is to develop a range of valuation of the inventory in order to evaluate management‘s estimate. Low

High

Selling price Advertising and shipping expenses

$ 78,000 7,000

$ 92,000 5,000

Auditors‘ estimate of the range for the inventory valuation

$ 71,000

$ 87,000

Yes, an adjustment can be proposed. Loss (or cost of goods sold) Inventory

$ 12,000 $12,000

Write down the inventory to the nearest end of the auditors‘ range ($99,000 client valuation minus the ―high‖ end of the auditors‘ valuation). b.

4.59

No adjustment is necessary. The management estimate of $80,000 is within the auditors‘ range estimate.

Risk Assessment We gratefully acknowledge the assistance of Jeanie Folk in developing the following solution: Recall that audit risk is the risk that the auditor will give an inappropriate opinion on financial statements (e.g., giving an unqualified opinion on the financial statements that are misleading because of material misstatements that auditors failed to discover. The problem adds the perspective that the audit risk at the overall financial statement level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to management, the industry, and the company. 1. Decrease. Ordinarily, the fact that this is the first profitable year after a string of losses would cause concern. The auditor might suspect an overstatement of revenues or understatement of expenses. However, in this situation, the increase in revenues (and net income) appears to be the result of additional federal and state funding for environmental purposes to TWD‘s customers, which are municipalities. Given that TWD has a limited number of customers, the year-end receivables (and even revenue) can be confirmed with those municipalities. As such, there would be no increase in audit risk. The decrease in audit risk would result from lessening the company‘s need to get through a ―difficult period,‖ that is, the years of losses. 2. Increase. TWD‘s board of directors is controlled by its major stockholder who also acts as the company‘s CEO. That person may act in his or her best interests rather than in accordance with those of the minority shareholders and other financial statements. The potential for financial statement fraud would increase as a result. 3. Increase. The internal auditor reports to the Controller, who has responsibility for the company‘s accounting system and the preparation of its financial statements. The internal auditor should report to the audit committee so that objectivity is maintained. Because the controller could steer the internal auditor away from problem areas, audit risk would be increased. 4. Increase. Turnover is a red flag that the department might have problems. Additionally, turnover resulted in the hiring of inexperienced people (at least inexperienced with respect to TWD). 5. Decrease. Having an external party such as a bank loan officer involved in an ongoing review of the company‘s performance would enhance the company‘s system of internal controls.

6. No effect. The payment of employees on a weekly, biweekly, monthly, or other basis would have no effect on audit risk. 7. Decrease. Bond has audited TWD for five years. As a result, because Bond is familiar with the industry, the company, and its management team, Bond is in a position to identify information necessary to assess fraud risk factors, identify those risk factors, and assess fraud risk than the firm would be if it had little or no experience with this client. 8. Increase. Changing accounting practices increases inherent risk (the susceptibility of the accounts to misstatement). 9. Increase. TWD sold one-half of its controlling interest in UEL; its remaining interest is significant. As such, TWD now has significant influence over but no longer controls the operations of UEL. With its lower influence and knowledge of UEL, TWD is not as able to assess the risk of fraudulent financial reporting by UEL. UEL‘s results still impact TWD‘s financial statements (because the equity method would be used in cases of significant influence) and, as such, the audit risk relating to TWD‘s financials would accordingly increase. 10. Decrease. If the litigation were disclosed in prior years, either the potential loss was probable but could not be reasonably estimated or it was reasonably possible. In either case, the amount of potential loss must have been material. Because the litigation was dropped by the state, there is less uncertainty about the impact of this pending litigation on the company‘s financial position and results of operations. 11. Increase. Related-party transactions generally increase the risk of fraud, especially because the transactions were not previously disclosed. 12. Increase. In December, This barter transaction is not only unusual, but will also present problems in terms of the measurement of the revenue earned. As such, audit risk will increase. 13. No effect. Inherent risk is a component of risk of material misstatement. However, insurance coverage, or the lack thereof, has no impact on inherent risk, which is the risk that, in the absence of internal controls, material errors or frauds could enter the accounting system used to develop financial statements. Furthermore, having such coverage would lower the business risk for the company. 14. Increase. Recall that revenues must be matched with all costs incurred to earn that revenue. As such, the cost, if any, of the guarantees issued must be estimated and recorded in the current year.

Given the lack of historical information and difficulties involved in estimating the potential cost of its guarantee (and even considering the difficulties involved of determining whether the municipality has any responsibility for actions that might impact the results of the site inspections) that may materially impact the current year‘s financial statements, audit risk will increase. 15. Increase. Generally, public offerings are successful for companies with strong financial performance. As such, going public often creates motivation for making the company appear as strong as possible. Audit risk would increase as a result. 4.60

Audit Standards Review a. Management fraud is deliberate fraud committed by management that injures investors and creditors through materially misleading financial statements. The class of perpetrators is management, the class of victims is investors and creditors, and the instrument of perpetration is the financial statement. Sometimes management fraud is called fraudulent financial reporting, defined as ―intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements.‖ Defalcation is another name for employee fraud, embezzlement, and larceny. Employee fraud is the use of fraudulent means to take money or other property from an employer. It usually involves falsifications of some kind—false documents, lying, exceeding authority, or violating an employer‘s policies. Embezzlement is a type of fraud involving employees‘ or nonemployees‘ wrongfully taking money or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and coverup. Larceny is simple theft—for example, an employee taking an employer‘s money or property that has not been entrusted to the custody of the employee. b.

Auditors are responsible for assessing the risk of material misstatements due to management fraud and due to misappropriation of assets (employee fraud). They should (1) consider this assessment when designing procedural responses (overall response and specific procedural response), (2) ask management about its understanding of fraud risk in the company, (3) pay attention to fraud risk factors, (4) document the risk assessment and management knowledge in the audit documentation, (5) determine whether the company has specific controls to mitigate fraud risks, (6) consider the effectiveness of the company‘s prevention, detection, and deterrence programs, and (7) perform procedures to provide a reasonable assurance of detecting material misstatements due to fraud.

Characteristics of management fraud important for consideration: materiality of the effect on financial statements, the level of management involved, the extent and skillfulness of concealment, the relationship to control activities, the specific accounts affected.

Concern-heightening factors:                  

Management decisions are dominated by an individual or small group. Managers‘ accounting attitudes are unduly aggressive. Managers place much emphasis on meeting earnings projections. Management‘s business reputation is poor. Management has engaged in opinion shopping. Managers are evasive responding to auditors‘ inquiries. Managers engage in frequent disputes with auditors. Managers display significant disrespect for regulatory bodies. Company has a weak internal control environment. Company accounting personnel are lax or inexperienced in their duties. Company employs inexperienced managers. Company is in a period of rapid growth. Company profit lags the industry. Company has going concern problems (near bankruptcy). Company is decentralized without adequate monitoring. Company has many difficult accounting measurement and presentation issues. The company may be offered for sale. The company makes acquisitions using its stock.

These next ―red flags‖ have more to do with employee frauds (misappropriations of assets) than management fraud, but auditors are supposed to know about them:                  

Missing documents. Second endorsements on checks. Unusual endorsements. Unexplained adjustments to inventory balances. Unexplained adjustments to accounts receivable. Old items in bank reconciliations. Old outstanding checks. Customer complaints. Unusual patterns in deposits in transit. Cash shortages and overages. Excessive voids and credit memos. Customer complaints. Common names or addresses for refunds. Adjustments to receivables and payables. General ledger does not balance. Increased past due receivables. Inventory shortages. Increased scrap.

      e.

Alterations on documents. Duplicate payments. Employees cannot be found. Second endorsements on checks. Documents photocopied. Dormant accounts become active.

Auditor disclosure might be required: (1) To comply with legal and regulatory requirements (including reporting a change of auditors on SEC Form 8-K, control matters and disagreements according to Item 304 of SEC Regulation S-K).

4.61

(2)

To report to the SEC under the requirements of the Private Securities Litigation Reform Act (when illegal acts material to the financial statements are not reported to the SEC by the company‘s board of directors).

(3)

To respond to new auditors‘ inquiries.

(4)

To respond to a subpoena.

(5)

To communicate with a funding or other agency when required in audits of entities that receive governmental financial assistance.

Analytical Procedures: Ratio Relationships a.

The current ratio was higher than it should have been. The current asset numerator was higher (fictitious accounts receivable more than the inventory removed), but the current liability denominator did not change. (However, if the income tax effect of the error is included, the current liabilities change by a higher percentage than the current assets change, and it turns out that the current ratio was made smaller!)

In this case, the relative rate of change is important because both the numerator and denominator of the current ratio are changed by the same amount. 1. Current ratio (before) was higher than 1:1—the incorrect accounting makes the ratio larger than it should be. Example: Before $100,000 / $20,000 = 5.0:1 After $ 90,000 / $10,000 = 9.0:1

Current ratio (before) was equal to 1:1—the incorrect accounting does not change the ratio. Example: Before $100,000 / $100,000 = 1:1 After $ 90,000 / $ 90,000 = 1:1

Current ratio (before) was less than 1:1—the incorrect accounting makes the ratio smaller than it should be. Example: Before $ 20,000 / $100,000 = 0.2:1 After $ 10,000 / $ 90,000 = 0.11:1

Effect of unrecorded purchase counted in physical inventory, assuming the accounts are adjusted to include the inventory on hand. Inventory is not misstated. Cost of goods sold is understated. Gross profit is overstated. Net income is overstated. The effect on the ratios compared to what they would have been without the error: Current ratio: Higher than 1:1 before. Equal to 1:1 before Less than 1:1 before Gross margin ratio Cost of goods sold ratio Inventory turnover

Receivables turnover:

The error of recording the inventory but not the current payable makes the ratio larger. The error makes the ratio higher. The error makes the ratio higher. The error makes it higher. The error makes it lower. The error understates purchases and cost of goods sold, which is the numerator in inventory turnover. Therefore, the ratio is understated. The error does not affect either the sales numerator or the receivables denominator, so the ratio is not affected.

In this case, the net receivables amount is correct. The proper adjustment should be to reduce gross receivables and the allowance for doubtful accounts by an equal amount. Current ratio: Not affected because the current asset and current liability totals are not affected. Day‘s sales in receivables: Not affected when the net receivables is used to calculate the ratio. Doubtful account ratio: The improper accounting causes the ratio to be larger than it should be. (Proper accounting would cause the allowance numerator to be reduced to a greater extent, and by a faster rate than the receivables denominator.) Receivables turnover: Not affected when the net receivables is used to calculate the ratio. Return on beginning equity: Not affected because the income is measured properly with adequate allowance for doubtful accounts. Working capital/Total assets: Not affected because both terms are measured properly. e.

The effect on the Altman (1968) discriminate Z score is a higher score because of the directional effect of all the changes mentioned: Working capital (WC) /Total assets (TA): The ratio is higher because WC is higher and TA is smaller. Retained earnings / Total assets: The ratio is larger because retained earnings remained the same while TA is smaller. Earnings BIT / Total assets: The ratio is larger, because EBIT is about the same as last year, and TA is smaller. Market equity / Total debt: The ratio is higher because market equity is the same while total debt is lower. Net sales / Total assets: The ratio is higher because net sales have decreased less (5%) than the total assets have decreased (10%).

4.62

Audit Strategy Memorandum

4.63

This is another open-ended assignment intended to offer students an opportunity to relate risks to audit procedures. Appendix 4.B offers an example of how to complete this memo. Students should be able to garner significant accounts and assertions from the financial statements. The 10-K will have some specific risks for them to address. Developing controls and audit procedures for the risks will require some imagination and creativity. At this stage of the course, they should be allowed a great deal of latitude because specific knowledge of controls and procedures will be discussed in later chapters. Errors and Frauds Students can probably think of many examples for each of the cases. This solution does not purport to be exhaustive. a.

Overstate an asset, understate another asset Hold cash receipts journal open past the year-end (cutoff date) and record additional cash receipts occurring after year-end, reducing accounts receivable.

Overstate an asset, overstate stockholder equity Record appraised value of property, plant, and equipment with a corresponding credit to a capital account.

Overstate an asset, overstate revenue (1) Hold the sales journal open past the year-end (cutoff date) and record too much sales revenue and cash or accounts receivable. (2) Record fictitious sales and accounts receivable.

Overstate an asset, understate an expense (1) Capitalize maintenance expense, making the asset amount higher than warranted and the expense amount lower. Subsequent depreciation would reverse this misstatement, but the first effect would be to overstate the asset and understate the expense. (2) Record an expenditure as a prepaid expense instead of a current expense.

Overstate a liability, overstate an expense Accrue too much liability for expenses not yet paid, such as wages, rent, interest, product warranties

Understate an asset, overstate an expense (1) Calculate too much depreciation expense on assets. (2) Classify expenditures as current expenses when they should be classified as prepaid expenses.

Understate a liability, understate an expense Fail to accrue liabilities for expenses not yet paid, such as wages, rent, interest, product warranties.

4.64 Compliance with Laws and Regulations a. Auditors must plan their procedures to detect noncompliance with laws and regulations that have a direct effect on the financial statements to provide reasonable assurance that the financial statements are not materially misstated. Auditors must also respond to all actual or suspected noncompliance identified during the audit. First they must gain an understanding of the nature and circumstances of the noncompliance and then evaluate the possible effect on financial statements. The noncompliance should be discussed with management at a level above the person responsible for the noncompliance. If noncompliance is ―clearly inconsequential,‖ that may be the extent of the follow-up. Noncompliance or suspected noncompliance having financial statement effects higher than this threshold should be reported to those charged with governance such as the audit committee, and the financial statements should contain adequate disclosures about the organization‘s noncompliance. Discussion with the client‘s legal counsel may also be necessary. External auditors always have the option to withdraw from an engagement if management and directors do not take satisfactory action in the circumstances. b. Type of Noncompliance 1. D 2. I 3. I 4. D 5. D 6. I 7. D

8. D 4.65

Explanation Directly affects tax expense and accrual accounts Does not have direct effect on a specific account or disclosure Does not have direct effect on a specific account or disclosure Directly affects Inventory account Directly affect reserve for losses account. A violation of the Foreign Corrupt Practices Act but does not have a direct effect on a specific account or disclosure Directly effects accrual of compensation expense. In addition, the PCAOB Staff Audit Practice Alert No. 1 states: ―Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock option grants and, as a result, may have materially misstated its financial statements or may have deficiencies in its ICFR. …the auditor should acquire sufficient information to allow him or her to assess the nature and potential magnitude of these risks. An auditor must use professional judgment in making these assessments and in determining whether to apply additional procedures in response. Directly affect pension plan reserve account

Identifying Significant Accounts Apple‘s 10-K can be found at https://investor.apple.com/sec-filings/default.aspx. This is a very openended question. Students‘ responses could be quite varied. The best classroom strategy is to start with soliciting student responses for what they consider a red flag based off of the risks disclosed. From there, students should think about what accounts would be related to that risk area and what management assertions they would be most concerned about related to that account. 1-113 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4.66 Producing an aging schedule using the parameters in the IDEA workbook produces the following report:

The aging blocks shown indicate the accounts that are less than the Interval number of days aged. Thus, accounts in the ―31‖ block are those accounts where the invoice occurred no more than 30 days ago. Therefore, accounts in the 91 interval includes accounts that are 90 or fewer days delinquent (59-90 days). a. The number of customer records greater than 90 days delinquent include the three accounts in the 120 and 121 plus blocks. As a percentage, 1.19% of accounts are aged more than 90 days. b. The percentage of customer balances greater than 90 days are 1.48 doing the same calculation on the net value. c. The account and assertion most influenced by an aging analysis is the valuation of accounts receivable. The analysis in parts a and b indicate that Bright IDEAs does not have a significant problem with accounts that are substantially past due. However, they do seem to have an issue with slow paying because approximately 35% of invoices and amounts are more than 30 days aged.

4.67 a. Students should follow along with the IDEA Workbook v10, pages 201-204 to complete this exercise. The solution and screenshots of the approach are shown in the Workbook. b. As a result of the findings in part (a), the risk of material misstatement for the valuation assertion related to the inventory account should likely remain the same. The identification of obsolete inventory has revealed a very low level of obsolescence (i.e., less than 2%). As a result, the risk of material misstatement will likely remain the same and the testing approach for this assertion is not likely to change as a result of this analysis. 4.68 a.-b. Students should follow along with the IDEA Workbook v10, pages 220-228 to complete these exercises. The solutions and screenshots of the approach are shown in the Workbook. c. As a result of these findings in parts (a) and (b), the risk of material misstatement for the valuation (accuracy) assertion related to the revenue account should be assessed higher. The profit margin analysis has revealed some significant price increases that have resulted in very high profit margins. As a result, the risk of material misstatement needs to be assessed higher which will lead to changes in the nature, timing and extent of testing for the valuation (accuracy) assertion related to revenue. The analysis did not reveal major concerns related to negative profit 1-114 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

margins. As a result, this aspect of the analysis is not likely to impact the risk of material misstatement.

CHAPTER 05 Risk Assessment: Internal Control Evaluation LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

20. Define and describe what is meant by internal control.

1, 2, 16

21. Distinguish between the responsibilities of management and auditors regarding an entity‘s internal control.

22. Define and describe the five basic components of internal control and specify some of their characteristics.

7, 8, 9, 10, 11, 12, 13, 14, 15

56, 63

23. Explain the process the audit team uses to assess control risk, understand its impact on the risk of material misstatement, and, ultimately, to know how it affects the nature, timing, and extent of further audit procedures to be performed on the audit.

4, 5, 6, 17, 18, 19, 20, 21, 22, 23

30, 31, 33, 34, 35, 36, 37, 38, 48, 50, 53

55, 57, 59, 60, 62, 64, 65

24. Describe additional responsibilities for management and auditors of issuers required by Sarbanes–Oxley and PCAOB Auditing Standard No. 2201.

24, 25, 26, 27

32, 39, 40, 41, 42, 43, 44, 45, 46, 47, 49, 51, 52, 54

25. Explain the communication of internal control deficiencies to those charged with governance such as the audit committee and other key management personnel.

SOLUTIONS FOR REVIEW CHECKPOINTS 5.1

The Committee of Sponsoring Organizations (COSO) included representatives from the Financial Executives Institute, the American Accounting Association, the Institute of Internal Auditors, the Institute of Management Accountants, and the AICPA. The committee was formed in 1985 in direct response to a scathing report issued by the National Commission on Fraudulent Financial Reporting. The goal of the committee was to determine what business entities could do to improve financial reporting. The committee spent a significant amount of time debating internal control theory and definitions. The primary purpose of the COSO framework is to provide a benchmark for internal control effectiveness. Specifically, in 1992, the COSO committee set forth a definition of what is meant by an effective internal control system.The COSO framework defines internal control as a set of policies and procedures designed to achieve management objectives in three different categories. In the financial reporting category, the management objectives are related to producing reliable financial reports and safeguarding assets. In the operations category, some examples of management objectives are maintaining a good business reputation, ensuring a positive return on investment, increasing market share, promoting new product innovation, and using assets effectively and efficiently. In the compliance category, the broad management objective is to comply with laws and regulations that affect the entity. In 2013, COSO published an updated version of the framework. The updated framework acknowledged the widespread use of the original COSO framework and desired to build upon the core tenets and definitions established in the original framework. A key goal of the updated version is to provide ―enhancements and clarifications intended to ease use and application‖ of the framework in an ever-changing global environment.

5.2

The three goals of an internal control system, according to the Committee of Sponsoring Organizations (COSO) Report, are:  Reliability of financial reporting.  Effectiveness and efficiency of operations.  Compliance with applicable laws and regulations. External auditors are primarily concerned with the reliability of financial reporting; however, some operating and compliance controls may be important for the financial statement audit depending on the facts and circumstances of the audit engagement.

5.3

As stated in the Sarbanes-Oxley Act of 2002, management is responsible for establishing a system of internal control. Management is responsible for establishing the control environment, assessing the risks it wishes to control, specifying information and communication channels and content (including the accounting system and its reports), designing and implementing control activities, and monitoring, supervising, and maintaining the controls. Management of public companies must report their evaluation of the company‘s financial reporting controls on an annual basis to the shareholders. External auditors are not responsible for designing effective controls for audit clients. They are responsible for evaluating existing internal control and assessing the control risk in them. For public companies, auditors must give an opinion on the effectiveness of internal control over financial reporting based on an audit of internal control that is integrated with the financial statement audit.

5.4

Control risk is the probability that the client‘s internal control activities will fail to prevent or detect material errors and frauds that enter the data processing system. Assessing control risk is part of using the audit risk model in the planning stage of the audit. That is, auditors determine the nature, timing, and extent of further substantive audit procedures (i.e., set detection risk) based, in part, on the assessment of control risk for each relevant financial statement assertion. The other important assessment that auditors have to make to determine the nature, timing and extend of further audit procedures is the inherent risk assessment. See review checkpoint 5.7 for further discussion.

5.5

The primary reason for conducting an evaluation of a client‘s existing internal control system is to give the auditors a basis to determine the nature, timing, and extent of further substantive audit procedures. On a public company audit, Sarbanes-Oxley requires auditors of public companies to perform an audit of internal control over financial reporting that is integrated with the financial statement audit.

5.6

The audit team assesses control risk to determine the risk of material misstatement (RMM) for each relevant assertion identified in the audit plan; the higher the assessment of control risk, the higher the assessment of RMM. Most audit teams express their control risk assessment decision with descriptive terminology (e.g., high, moderate, low), which recognizes the imprecise nature of evaluating risk. Audit teams‘ assessment of control risk as high implies that the controls are not effective at preventing or detecting material misstatements and could not be relied on by audit teams. In this situation, audit teams would likely use substantive tests of details designed to obtain the highest quality of external evidence (nature) at or near the entity‘s fiscal year-end (timing) with large sample sizes (extent). On the other hand, audit teams‘ assessment of control risk as low implies that the controls are effective at preventing or detecting material misstatements and could be relied on by auditors. In this situation, the audit teams might be able to use tests of detail or a less time-consuming substantive analytical review to obtain external evidence (nature) at an interim date before the entity‘s fiscal year-end (timing) with much smaller sample sizes (extent). Of course, audit teams may assess control risk as moderate and adjust the substantive procedures accordingly in order to obtain enough evidence to mitigate the risk of material misstatement to a low level for the relevant assertion being tested.

5.7

The COSO Report states that management‘s internal control consists of five interrelated components:  Management‘s control environment.  Management‘s risk assessment.  Management‘s control activities.  Management‘s information and communication systems.  Management‘s monitoring of controls.

5.8

The control environment sets the tone of the organization. It is the foundation for all other components of internal control. It provides discipline and structure. Control environment factors include the integrity, ethical values, and competence of the company‘s people. The following are general elements of an internal control environment:  Integrity and ethical values: Sound integrity and ethical values, particularly of top management, are developed and understood and set the standard of conduct for financial reporting.  Board of directors: The board of directors understands and exercises oversight responsibility related to financial reporting and related internal control.  Management’s philosophy and operating style: Management‘s philosophy and operating style support achieving effective internal control over financial reporting.  Organizational structure: The company‘s organizational structure supports effective internal control over financial reporting.  Financial reporting competencies: The company retains individuals competent in financial reporting and related oversight roles.  Authority and responsibility: Management and employees are assigned appropriate levels of authority and responsibility to facilitate effective internal control over financial reporting.  Human resources: Human resource policies and practices are designed and implemented to facilitate effective internal control over financial reporting.

5.9

An audit committee is a subcommittee of the board of directors that is generally composed of three to six ―outside‖ members (those not involved in the entity‘s day-to-day management) of the organization‘s board of directors. Each member must be financially literate, and one member must be a ―financial expert.‖ 1-117 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

A key purpose of the audit committee is to provide a buffer between the audit team and the upper management team. Ultimately, the audit committee is responsible for reliable financial statement reporting. Some of the more important duties of the audit committee follow:    

Appointment, compensation, and oversight of the public accounting firm conducting the entity‘s audit. Resolution of disagreements between management and the audit team. Oversight of the entity‘s internal audit function. Approval of nonaudit services provided by the public accounting firm performing the audit engagement.

5.10

The purpose of risk assessment is to identify and control for those factors, events, and conditions that may prevent the organization from achieving its business objectives. Management should take steps to identify risks, estimate their significance and likelihood, and consider how to manage the risks. By setting management objectives, management can identify critical success factors and institute policies and procedures to help ensure that they are met.

5.11

A control activity is an action taken for the purpose of preventing, detecting, or correcting errors and frauds in transactions to eliminate, mitigate, or compensate for risks identified by management.

5.12

Preventive controls are designed to keep misstatements from occurring, whereas detective controls are designed to find misstatements if they occur. Examples of preventive controls would be hiring competent people, requiring approvals, creating separation of duties, and safeguarding assets. Examples of detective controls would be account reconciliations, business performance reviews, and control totals.

5.13

Four kinds of functional responsibilities that should be separated to promote strong internal control:  Authorization to execute transactions.  Recording of transactions in the accounting system.  Custody of assets.  Periodic reconciliation (comparison) of existing (real) assets to recorded amounts.

5.14

The information and communication component is closely related to the accounting information system. The accounting information system produces a trail of activities from the identification of data elements in a transaction all the way to the general ledger (i.e., financial reports). This trail of activities is referred to as the audit trail. You can visualize that the audit trail begins with the source documents (purchase orders, sales orders, etc.) and proceeds through to the financial reports. Auditors often follow this trail frontward and backward, identifying and testing relevant control activities along the way. They follow it backward from the financial reports to the source documents to determine whether everything in the financial reports is supported by appropriate source documents (the occurrence assertion). They follow it forward from source documents to reports to determine whether everything that happened (transactions) was recorded in the accounts and reported in the financial statements (the completeness assertion).

5.15

Examples of everyday monitoring work that can be done by management would include:  Periodic evaluation of controls by internal audit.  Analysis of and appropriate follow-up of operating reports or metrics that might identify anomalies indicative of a control failure.  Supervisory review of controls, such as reconciliation reviews as a normal part of processing.  Self-assessments by boards and management regarding the tone they set in the organization and the effectiveness of their oversight functions.  Audit committee inquiries of internal and external auditors.  Quality assurance reviews of the internal audit department Interestingly, some of the control activities that have been discussed in this chapter also serve as monitoring activities. For example, analyzing customer complaints for follow-up is a control activity, but analyzing 1-118 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

them to determine whether the complaints result from a weakness in other controls (e.g., a failure to compare shipping documents to customer orders) would be considered a monitoring activity. Thus, you need to think about the all of the purposes of a control activity to determine whether it has a monitoring component to it. Finally, ongoing monitoring activities of small and midsize entities are more likely to be informal and are typically performed as a part of the overall management of the entity‘s operations. For example, the management team‘s close involvement in operations will often result in the identification of significant variances from expectations and inaccuracies in financial data. 5.16

Reasonable assurance is closely related to the cost-benefit rule. By definition, reasonable assurance recognizes that the cost of an organization‘s internal control should not exceed the benefits obtained by the control. Management is responsible for assessing the cost and benefits of internal controls in their own organizations, hence their reasonable assurance. Auditors get into the act of reasonable assurance assessment when they audit internal controls and when they consider whether to make recommendations about control improvement in a management letter. Both parties must consider that the SEC regards reasonable assurance as a high standard that means the probability of controls not detecting or preventing material misstatements is remote. The key limitations in an internal control system generally relate to the people operating within the system. People make the system work at every level of company management. People establish the objectives, put control mechanisms in place, and operate them. There are at least four types of breakdowns related to people. They are human error, deliberate circumvention, management override, and improper collusion among people who are supposed to act independently. Internal control can help prevent and detect these people-caused failures, but it cannot guarantee that they will never happen.

5.17

A ―top-down‖ approach begins with identifying significant accounts and relevant assertions that have a reasonable likelihood of containing a material misstatement. In other words, these are the accounts that are inherently more risky, without considering how internal controls may ultimately mitigate those risks. Once this is performed for significant accounts and assertions, an auditor will seek to identify and examine both entity-level controls and process-level controls to determine whether they have been designed to mitigate the risk of material misstatement related to the significant account and relevant assertions. This process has also been described as first identifying ―what could go wrong?‖ in the financial statements and then determining ―what is the company doing about it?‖ to prevent or detect a misstatement in the financial statements.

5.18

No. This answer depends on whether it is a public (issuer) or privately held (nonissuer) audit client and on whether the auditor plans to rely on internal controls to reduce substantive testing. For every audit of a public company, the auditors must assess and test controls because they will have to issue an opinion on the effectiveness of internal controls. However, for a privately held client, the phase 1 understanding must always be followed by a control risk assessment phase and the auditors‘ documentation of their understanding of the internal control system. Control risk that is assessed at less than 100% implies that the auditors plan to rely on controls to reduce substantive procedures. If that is the case, the auditors must ultimately test the operating effectiveness of internal controls to confirm their preliminary assessment of control risk. If not, there is no need to conduct any testing on internal controls.

5.19

An auditor can find client‘s documentation of the accounting system in a number of places, including:     

Chart of accounts. Accounting manual—definitions and instructions about measuring and classifying transactions. Computer systems and program documentation. Systems and procedures manuals. Flowcharts of transaction processing.



Various paper forms.

5.20

Advantages and disadvantages of using (a) an internal control questionnaire, (b) a narrative memorandum, and (c) a flowchart are: (a)

Advantages of an internal control questionnaire:  Is easy to complete.  Has checklist of questions.  Decreases chance of overlooking something important. Disadvantages:  May contain numerous irrelevant questions.  Tends to be treated like another form to fill out.

(b)

Advantages of a narrative memorandum:  Can explain the precise controls applicable to the particular client (precise tailoring).  Requires penetrating analysis.  Minimizes tendency toward perfunctory review. Disadvantages:  Is difficult to write and often lengthy.  Is difficult to revise in subsequent years.

(c)

Advantages of flowchart:  Provides graphic presentation of systems.  Shows the steps required and the flow of forms and documents.  Is easy to read and analyze.  Is easy to update in subsequent years. Disadvantages:  Takes a significant amount of time to complete.  Can be quite complex, requiring specific skills to complete.

5.21

A test of control activities is an audit procedure designed to produce evidence about the operating effectiveness of a client‘s control activity. A test of controls is completed using some combination of inquiry, observation, document examination, and/or reperformance.

5.22

When testing controls, document examination or inspection refers to auditors determining whether client personnel actually stamped, initialed, or left other signs on documentary evidence that their assigned control activities had been performed. When testing controls, reperformance refers to auditors actually completing the control activity (again) that were supposed to have been performed by the client personnel (recalculating, looking up the right price, comparing quantities, and so forth). The key difference between document examination and reperformance is that with the former, audit teams inspect documents for evidence that employees have performed the control activity; reperformance provides evidence that the control activity was (or was not) done correctly.

5.23

A ―dual-purpose test‖ serves the purposes of obtaining evidence (1) about the operating effectiveness of a client‘s internal control activity (test of control) and (2) to help detect material misstatements in account balances and disclosures (substantive procedure). Because the test is helping an auditor achieve two objectives at the same time, dual-purpose tests can greatly help with the efficiency of the audit.

5.24

Management is responsible for establishing and maintaining effective internal control over financial reporting; performing an evaluation and concluding about the effectiveness of the entity‘s internal control over financial reporting; and disclosing to the audit team any frauds resulting in a material misstatement to the entity‘s financial statements (as well as any other immaterial fraud that involves key managers), all significant deficiencies, and any material weaknesses identified during its evaluation. Management cannot use the auditors‘ procedures performed during the audits of internal control over financial reporting or the financial statements as part of the basis for its assessment of the effectiveness of internal control over financial reporting.

5.25

The steps for auditing internal controls over financial reporting are: (a) Plan the engagement (b) Use a top-down approach to gain an understanding. (c) Test controls. (d) Evaluate identified control deficiencies. (e) Wrap up by forming an opinion on the effectiveness of internal control over financial reporting. (f) Report on internal control.

5.26

(a) An internal control deficiency is a condition that exists when the design or operation of a control does not allow the company‘s management or employees to detect or prevent misstatements in a timely fashion. (b) A significant deficiency is defined as a deficiency or a combination of deficiencies in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance. (c) A material weakness in internal control is defined as a deficiency or combination of deficiencies that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis.

5.27

One option is to have two separate reports: one on the fairness of the entity‘s financial statements (presented earlier in Chapter 2) and one on internal control over financial reporting. Each report would be separately titled, dated (although using the same date), and signed. The second option is to prepare a combined report that expresses one opinion on the financial statements and a second on the effectiveness of internal control over financial reporting. The combined report is far more common in the practice of auditing (presented in Chapter 12).

5.28 Auditors must communicate significant deficiencies and material weaknesses that come to their attention in the performance of the audit to management, the board of directors, or its audit committee. Auditors often issue a type of report to management called a management letter. This letter may contain commentary and suggestions on a variety of matters in addition to internal control matters.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 5.29

Incorrect

Effectiveness and efficiency is an objectives category, not a foundational component. b. Correct The control environment is is the most important foundational component of the internal control system. All other components are dependent, in part, on the effectiveness of the control environment. c. Incorrect Reliability of financial reporting is an objectives category, not a foundational component. d. Incorrect Compliance with laws and regulations is an objectives category, not a foundational component. 5.30

a. b. c. d.

Incorrect Correct Incorrect Incorrect

Management letter suggestions are a secondary purpose. These are the auditors‘ responsibilities under GAAS. This does not relate only to internal control. Communication of control related matters is a secondary purpose.

5.31

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Incorrect

Correct

Incorrect

c. d.

Correct Incorrect

5.34

a. b. c. d.

Incorrect Incorrect Correct Incorrect

This is a detective control. This is a detective control. This is a preventive control. This is a detective control.

5.35

Incorrect

b. c.

Correct Incorrect

Incorrect

The absolute amount of cost is irrelevant. Year-end substantive work usually costs more than control evaluation work. The cost savings of substantive testing exceeds the control evaluation cost. Whether the cost of control work exceeds (or does not exceed) the cost of year-end work is irrelevant. Efficiency relates to the cost that can be saved as a result of control evaluation work. Efficiency is not achieved by reducing cost of substantive procedures to less than control work cost.

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

5.37

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Substantive procedures produce evidence about financial statement assertions. Company control activities accomplish a company‘s management objectives. Analytical review is not accomplished with test of control activities. Tests of controls produce the evidence about actual operation of company control activities.

5.38

a. b. c. d.

Incorrect Correct Incorrect Incorrect

This describes an audit procedure. This is one way to describe the purpose of a transaction-level control activity. This is a definition of an accounting process or system. This is a description of one of the elements of the control environment.

5.32

5.33

5.36

Larger sample sizes expand audit procedures. Performing procedures at year-end instead of at interim generally represents stricter application. External evidence represents stricter application. Performing procedures at an interim date is less effective. The issue of whether the company‘s controls are processing data relates to the testing of operating effectiveness, not design effectiveness. The testing of design effectiveness relates primarily to whether the control has been properly put in place to prevent or detect errors or fraud. In AS5, this is exactly the objective of testing the design effectiveness of a control as per paragraph 42 of the standard. The issue of whether the company‘s employees are processing the controls in accordance with procedures relates to the testing of operating effectiveness, not design effectiveness. Letter b is the correct answer.

When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. This is a substantive test, not a test of a control‘s operating effectiveness. When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance.

The narrative is the documentation result of obtaining evidence. The internal control questionnaire is a device for collecting evidence in the form of answers to control questions. A flowchart is the documentation result of obtaining evidence. Only the internal control questionnaire aids in obtaining the evidence.

5.39

Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

The misstatement must be material. The possibility cannot be remote. By definition, a material weakness in internal control is defined as a deficiency, or combination of deficiencies that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis. The misstatement must be material.

5.41

a. b. c. d. e.

Incorrect Incorrect Incorrect Correct Incorrect

Both (a) and (c) are factors in determining the severity of a deficiency. Severity does not depend upon whether a misstatement has actually occurred. Both (a) and (c) are factors in determining the severity of a deficiency. Both (a) and (c) are factors. Whether a misstatement has occurred does not matter. Thus, (b) is not a factor.

5.42

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Gaining an understanding is required for audits of both types of entities. Documenting the understanding is required for audits of both types of entities. Evaluating control risk is required for audits of both types of entities. Testing controls is required only for audits of issuers under AS 2201.

5.43

a. b. c. d.

Incorrect Incorrect Correct Incorrect

AS 2201 does not apply to operation controls. AS 2201 does not apply to compliance with regulations. AS 2201 applies to financial reporting controls only. AS 2201 applies to financial reporting controls only.

5.44

a. b. c. d.

Incorrect Incorrect Correct Incorrect

AS 2201 requires auditors to issue a report on the audit of internal controls. AS 2201 only requires auditors to issue a report on the internal controls audit. AS 2201 requires auditors to issue a report on the audit of internal controls. AS 2201 only requires auditors to issue a report on the internal controls audit.

5.45

a. b. c. d.

Incorrect Incorrect Correct Incorrect

AS 2201 requires testing for design effectiveness and operating effectiveness. AS 2201 requires testing for design effectiveness and operating effectiveness. AS 2201 requires testing for design effectiveness and operating effectiveness. AS 2201 requires testing for design effectiveness and operating effectiveness.

5.46

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This indicates a possible material weakness. This indicates a possible material weakness. This indicates a possible material weakness. This does not directly relate to a material misstatement of the financial statements but is an operational issue.

5.47

a. b. c.

Incorrect Incorrect Correct

Incorrect

This is an appropriate report. This is an appropriate report. A disclaimer is used when the auditor‘s scope is limited but not when significant deficiencies exist, so it is not an appropriate report. This is an appropriate report.

5.40

The audit team identifies significant accounts, locations, and assertions in the planning stage of an audit of internal controls. The audit team conducts a walkthrough of the internal control process when gaining an understanding of the company‘s internal control. The audit team makes inquiries of employees regarding the existence of control activities when gaining an understanding of the company‘s internal control. The audit team reperforms control activities performed by client employees to determine their effectiveness when testing the effectiveness of the company‘s internal control.

5.48

Correct

Incorrect

This is an example of effective separation of duties. Separation of duties is designed to help the organization achieve effective internal control. To accomplish separation of duties, the payroll function should be divided into its authorization, recording, and custody functions. Authorization of hiring, wage rates, and deductions is typically completed by the human resources department. Authorization of hours worked is typically completed by the production department (or the department where the work was completed). Based on these authorizations, the accounting department would then calculate and record the payroll in the accounting system. Based on the calculated amounts, the treasurer would then prepare and distribute payroll checks. The distribution of paychecks is usually handled by the treasurer‘s department. Thus, this is not an appropriate example of separation of duties related to the distribution of paychecks. To accomplish separation of duties, the payroll function should be divided into its authorization, recording, and custody functions. Authorization of hiring, wage rates, and deductions is typically completed by the human resources department. Authorization of hours worked is typically completed by the production department (or the department where the work was completed). Based on these authorizations, the accounting department would then calculate and record the payroll in the accounting system. Based on the calculated amounts, the treasurer would then prepare and distribute payroll checks. The distribution of paychecks is usually handled by the treasurer‘s department. Thus, this is not an appropriate example of separation of duties related to the distribution of paychecks. To accomplish separation of duties, the payroll function should be divided into its authorization, recording, and custody functions. Authorization of hiring, wage rates, and deductions is typically completed by the human resources department. Authorization of hours worked is typically completed by the production department (or the department where the work was completed). Based on these authorizations, the accounting department would then calculate and record the payroll in the accounting system. Based on the calculated amounts, the treasurer would then prepare and distribute payroll checks. The distribution of paychecks is usually handled by the treasurer‘s department. Thus, this is not an appropriate example of separation of duties related to the distribution of paychecks. To accomplish separation of duties, the payroll function should be divided into its authorization, recording, and custody functions. Authorization of hiring, wage rates, and deductions is typically completed by the human resources department. Authorization of hours worked is typically completed by the production department (or the department where the work was completed). Based on these authorizations, the accounting department would then calculate and record the payroll in the accounting system. Based on the calculated amounts, the treasurer would then prepare and distribute payroll checks.

5.49

5.50

5.51

5.52

a. b.

Incorrect Incorrect

The reporting option when a scope limitation exists is a disclaimer of opinion. A qualified opinion is not a valid reporting option for a scope limitation, and an adverse opinion would be issued only when one or more material weakness(es) is identified. While a disclaimer of opinion is one possible reporting option, it is not appropriate to issue an unqualified opinion if a significant scope limitation exists. The reporting option when a scope limitation exists is a disclaimer of opinion.

Incorrect

Correct

Incorrect

Correct

When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. Thus, response (a) and response (c) are appropriate responses. Thus, this is the correct answer.

Incorrect

The frequency with which a control operates is directly related to the extent of testing. For example, an auditor would have to have a much larger sample size when testing a control that operates on a daily basis, as compared to a control that operates on a monthly basis. The length of time that the auditor is planning to rely on a control is directly related to the extent of testing. For example, if an auditor wanted to rely on a control for a 3 month period of time, the extent of testing would be lower than if the auditor wanted to rely on the control for 12 months. The expected rate of deviation for a control that the auditor is planning to rely on is directly related to the extent of testing. For example, if an auditor expects

When an auditor plans to reduce control risk below the maximum and rely on controls to reduce substantive testing, they must make sure that the controls have been designed and are operating effectively in order to feel comfortable relying on such controls. The auditor cannot take the client‘s word that the controls are operating effectively. Rather, they must test the controls. An auditor would only reduce control risk below the maximum for those assertions where there is a control activity that they plan to place reliance. If the auditor is not relying on a control related to a particular assertion, there is no need to assess the control risk below the maximum and test controls. If the auditor plans to reduce control risk below the maximum, they would have to test the controls that are being relied upon. Thus, they could not just complete substantive testing. If the auditor plans to reduce control risk below the maximum, they would have to test the controls that are being relied upon. Thus, it goes beyond the response to fraud risk factors. When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. So, while inquiry is an appropriate response, it should be combined with reperformance. Thus, response (d) is the best answer. When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. Reading over the code of conduct would not be enough to test the operating effectiveness of a control. When testing the operating effectiveness of a control, the auditor should use a combination of inquiry, observation, inspection, and reperformance. So, while reperformance is an appropriate response, it should be combined with inquiry. Thus, response (d) is the best answer.

5.53

5.54

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

a larger deviation rate, he/she would want to gather a larger sample of evidence to make sure it was operating effectively. The relevance and reliability of the evidence to be obtained would not have an impact on the extent of testing to be completed. The extent of testing required should be determined and then the necessary evidence should be gathered. Evidence obtained during the test of controls would be relevant to the assessment of control risk. However, misstatements detected during the audit (response b) and control deficiencies detected during the audit (response c) would also be relevant. As a result, the correct answer is response (d), all of the above. Misstatements detected during the audit would be relevant to the assessment of control risk. However, evidence obtained during the test of controls (response a) and control deficiencies detected during the audit (response c) would also be relevant. As a result, the correct answer is response (d), all of the above. Control deficiencies detected during the audit. However, evidence obtained during the test of controls (response a) and misstatements detected during the audit (response b) would also be relevant. As a result, the correct answer is response (d), all of the above. Evidence obtained during the test of controls would be relevant to the assessment of control risk (response a); misstatements detected during the audit (response b); and control deficiencies detected during the audit (response c) would all be relevant. As a result, the correct answer is all of the above. An auditor may perform tests of other controls related to that same assertion. However, the first step would be to evaluate the severity of the deficiency on the auditor‘s control risk assessment for that assertion (response b). The first step an auditor is likely to take after detecting a control deficiency is to determine the impact of the severity of the deficiency on the auditor‘s control risk assessment for that assertion. The additional steps to be taken will depend in large part on this determination. An auditor may modify the planned substantive procedures as a result of the deficiency. However, before doing so, the auditor would have to evaluate the severity of the deficiency on the auditor‘s control risk assessment for that assertion (response b). Once the control is deemed deficient by the auditor, there is no need to conduct additional testing on that control. The auditor knows that the control is not operating effectively already.

SOLUTIONS FOR EXERCISES AND PROBLEMS 5.55

Internal Control Audit Standards a.

In planning an audit, the auditors‘ understanding of the internal control components should be used to identify the types of potential misstatements that could occur, to consider the factors affecting the risk of material misstatement, and to influence the design of substantive procedures.

An audit team obtains an understanding of the design of relevant internal control activities (policies and procedures) and whether they have been implemented. Assessing control risk below the maximum level further involves identifying specific control activities (policies and procedures) relevant to specific assertions that are likely to prevent or detect material misstatements in those assertions. It also involves performing tests of controls to evaluate the operating design and effectiveness of the client‘s control activities.

5.56

5.57

When seeking a reduction in the assessed level of control risk below the maximum, an audit team should consider whether additional audit evidence sufficient to support the reduction is likely to be available, and whether it would be efficient to perform tests of controls to obtain that audit evidence. If controls are tested and found to be effective, the final control risk assessment is low and detection risk can be set higher. As a result, the nature, timing, and extent of substantive procedures would likely be adjusted to reflect the increase in detection risk.

An audit team should document the understanding of a client‘s internal control system components to plan the audit as well as the basis for the conclusion about the assessed level of control risk. If control risk is assessed at the maximum level, the audit team should document that conclusion and the reasons for it. However, if the assessed level of control risk is below the maximum level, the audit team should document the basis for the conclusion that the effectiveness of the design and operation of internal control activities supports that assessed level.

Separation of Duties

Abigail Reconcile bank account

Maintain personnel records

Reconcile accounts receivable records to general ledger account

Bryan Open mail and list checks Prepare deposit and take to bank Maintain petty cash

Maintain general ledger

Chris Prepare checks for signature

Prepare payroll checks

Maintain accounts receivable records

Types of Audit Tests

Audit Test

Type of Audit Test

Assertion Tested

Discussion

Vouch recorded sales invoices to supporting shipping documents

Dual-purpose

Occurrence/existence

Tests the control designed to ensure validity of revenue transaction; provides substantive evidence related to the occurrence of revenue

Inspect recorded sales invoices for credit approval

Test of controls

Valuation, occurrence

Vouch recorded sales invoices prices to the approved price list

Test of controls

Accuracy

Tests the control designed to ensure that only paying customers are granted credit. Helps to support valuation of A/R; provides evidence in support of occurrence of revenue because you are selling to customers who you expect to pay Tests the control designed to ensure that accurate prices are charged to customers and recorded as revenue

Send confirmations to all customers regarding accounts receivable

Substantive test

Existence

Recalculate the arithmetic of recorded sales invoices.

Dual-purpose

Accuracy/valuation

Compare the shipment date of recorded sales invoices with the invoice record date

Dual-purpose

Cut-off/completeness

Trace recorded sales invoices to posting in the general ledger control account and in the correct customer‘s account

Dual-purpose

Completeness

Select a sample of shipping documents from the shipping department file and trace shipments to recorded sales invoices Scan recorded sales invoices and shipping documents for missing numbers in sequence.

Dual-purpose

Completeness

Test of controls

Completeness

Customers who confirm that they owe the client money provide substantive evidence that the receivable balance does exist (That is, why would a customer ever confirm an amount owed unless it was valid?) Tests the control designed to ensure that accurate amounts are charged to customers and recorded as revenue; provides substantive evidence about the value of revenue and related accounts receivable Tests the control designed to ensure that proper cutoff of revenue has been achieved; provides substantive evidence in support of the completeness of revenue as of year-end Tests the control designed to ensure that revenue is being recorded in the proper period; provides substantive evidence in support of the completeness of revenue as of year-end Tests the control designed to ensure that all shipments are properly recorded as revenue; provides substantive evidence supporting management‘s assertion of completeness. Tests the control designed to ensure that all shipments and sales invoices issued have been properly recorded in the financial statements; provides substantive evidence supporting the management assertion of

completeness

Vouch sales invoices and shipping documents

Dual-purpose

Occurrence/existence

Evaluate the adequacy of the allowance for doubtful accounts

Substantive test

Valuation

Obtain financial statements or credit reports on large past due accounts and inquire of the credit manager about collections m. Calculate an estimate of the allowance for doubtful accounts using prior relations of write-offs and sales

Substantive test

Valuation

Substantive test

Valuation

Tests the control designed to ensure validity of revenue transaction; provides substantive evidence related to the occurrence of revenue Provides substantive evidence that supports the valuation of accounts receivable; that is, allows the auditor to ascertain the collectability of accounts receivable Provides substantive evidence that supports the valuation of accounts receivable; that is, allows the auditor to ascertain the collectability of accounts receivable

Provides substantive evidence that supports the valuation of accounts receivable; that is, allows the auditor to ascertain the collectability of accounts receivable

5.58

Impact of Sarbanes-Oxley Act Answers will likely vary. However, please consider the following memo: Mr. Terry Puckett, CEO Central Office Supply, Inc. Indianapolis, IN Dear Terry, The Sarbanes-Oxley Act and the related PCAOB Auditing Standard Number 2201 will cause increased costs for Central Office Supply (COS) should your board of directors decide to go public. The specific effects regarding internal control reporting apply both to the management of COS and to the audit. You will be responsible for documenting, testing, and assessing the quality of your internal controls over financial reporting. This is usually a costly procedure; however, it will likely be beneficial for COS to have a firm grasp of the controls in place. You will have to prepare a written assessment whereby management accepts responsibility for the controls and evaluates their effectiveness as of the end of each year. You will have to support your evaluation with sufficient evidence, including documentation. As auditors, we will have to gather evidence to report on the effectiveness of COS‘ internal control. We will be able to use some of the tests your personnel perform, but the principal evidence for our report must be based on our own work. As a result, we will be conducting a significant number of control tests during the audit. We are unable to provide a precise estimate of the additional cost of the additional work, but it is true that many companies have seen their audit fees double as a result of the new requirements. The board should factor this possibility into the costs of going public. Sincerely, Your name, Audit Partner

5.59

Internal Control Questionnaire Items: Assertions, Tests of Controls, and Possible Errors or Frauds 1.

Occurrence: The control provides evidence that only valid payroll transactions are being recorded in the financial statements (i.e., no fictitious employees).

Select a sample of personnel files for new hires and terminations and trace to reports submitted to the personnel department. Trace also to first or last paycheck issued and to cumulative payroll records.

Paychecks might be delayed and terminated workers might continue to be ―paid‖ (with theft of check by someone else) if payroll is not promptly notified of new hires and terminations.

Select a sample of terminated employees. Interview their supervisors or the employees themselves for information about termination date. Search next payroll register for evidence of overpayment the next pay period.

5.60

Occurrence: The control provides evidence that the recorded payroll deductions are valid.

Select a sample of payroll deductions and vouch them to signed authorizations.

It is possible that incorrect amounts might be deducted from pay.

Same as tests of controls: Select a sample of paychecks, and vouch the deductions to the amount authorized according to the personnel files.

Occurrence: This control provides evidence that recorded payroll transactions are valid and properly authorized.

Observe the timekeeping operations to determine whether they are performed separately.

If payroll department personnel were also responsible for time records, they would have effective control over transaction authorization (i.e., hours worked approval) and could overpay themselves or friends.

Select the paychecks issued to the people involved in combined duties. Examine them for evidence of overpayment (wage rate or overtime).

Completeness: This control provides evidence that payroll and labor cost transactions are recorded in a complete manner.

Obtain reconciliation worksheets or checkoff reports and see whether the reconciliation was done.

Cost accounting records might contain more or fewer dollars than actually paid (per payroll data). Simple errors in cost analyses might occur.

If possible, obtain a total of labor charged to cost accounting jobs or processes, and reconcile to total wages reported on Federal Form 941. For details, select a sample of labor cost analyses and reconcile them to the payroll register for the same period.

Obtaining a ―Sufficient‖ Understanding of Internal Control Importantly, Jones has not proposed that the firm refrain from complying with GAAS. Under GAAS, the auditor must review and gain an understanding of the system of internal control and must document that understanding in the workpapers. However, under GAAS, the test of controls need be completed on those controls only on which the audit team believes to be strong and intends to rely on to reduce substantive procedures for a particular financial statement assertion. However, it is critical to point out that the auditor is required to gain enough of an understanding of internal control to know what could go wrong in the financial statements. This is a common problem in small CPA firms that audit small businesses. In such situations, the auditor can often complete the audit in an effective and efficient manner by merely completing extensive substantive testing with very little work done on the internal control system. For an auditor of a privately held company (not subject to Section 404 of Sarbanes-Oxley), this is a decision that is based purely on the economics (i.e., cost –benefit) of a particular audit engagement.

5.61

Fraud Opportunities The response by students could take several directions, including some or all of the following points: Material weakness: The facts seem to suggest ―a condition in which specific control features [few or none are described] or the degree of compliance with them do not reduce to a relatively low level the risk that errors or frauds in amounts that could be material to the financial statements may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.‖ Gault has authority and influence over too many interrelated activities. Nothing he does seems to be subject to review or supervision. He even is able to exclude the internal auditor.

An identification of the potential frauds will illustrate the misdeeds he can perpetrate almost single-handedly. 2.

Almost every desirable characteristic of good internal control has been circumvented: a.

Separation of functional responsibilities: Gault has authorization and custodial responsibilities.

Authorization and supervision: Gault is apparently subject to no supervision or review. The accounting staff is probably powerless to challenge transactions because of Simon‘s apparent approval of Gault‘s powers. The internal auditor should be independent within the company but not be in a position in which an employee can ask not to be audited.

Controlled access: The whole situation gives Gault access to necessary papers, records, and assets to carry out his one-man show.

Periodic comparison: No one else apparently has any access to the materials inventory in order to conduct an actual count for comparison to the book value (recorded accountability) of the inventory.

Potential frauds Gault could perpetrate include: a.

Colluding with customers to rig low bids and taking kickbacks, thereby depriving the company of legitimate revenue.

Directing purchases to favored suppliers, paying unnecessarily high prices, and taking kickbacks as well as even setting up a controlled dummy company to sell overpriced materials to the company. No competitive bidding control allows these fraudulent activities to possibly occur.

Through the control of physical inventory, (i) removing materials for himself and (ii) manipulating the inventory accounts to conceal shortages.

Ordering truck shippers to provide services for his own purposes and causing the charges to be paid by the company.

Manipulating the customer billing (similar to a.) to deprive the company of legitimate revenue while taking an unauthorized commission or kickback.

5.62

Internal Control Questionnaire Items: Errors that Could Occur from Control Weaknesses Questions (abbreviated) a. 1. Employees paid by check?

Possible Error or Fraud Due to Weakness 1.

Errors in withholding, rate

Special payroll bank account used? Hours for fictitious employee?

Bank reconciliation errors

Independent payroll check signers?

Fictitious employees, unauthorized payments

Independent bank statement reconciliation?

Fictitious employees, incomplete accounting

Payroll employees rotated, take vacations, and bonded?

Fictitious employees

Timekeeping independent of payroll?

Fictitious employees or hours

Wage rates approved?

Unauthorized rates, improper rates

Deduction authorizations signed by employees?

Incorrect deductions

Hours and cost distribution approved by supervisor?

Hours overcharged (fictitious hours)

10. Time clock used?

10. Incorrect hours claimed and paid

11. Payroll sheet signed and approved?

11. Unauthorized employees, hours, or rate

12. Personnel department reports employees terminated to payroll department?

12. Terminated employees paid and another cashes checks (fictitious employee)

13. Payroll compared to personnel files?

13. Fictitious employees

14. Independent check distribution?

14. Fictitious employees

15. Unclaimed wages controlled?

15. Improper cashing of checks

16. Occasional surprise payoff by internal auditors?

16. Fictitious employees

17. Personnel department reports employees hired to payroll departments?

17. Unauthorized employee paid. (Fictitious employee)

18. Payroll checks prenumbered? Sequence checked?

18. Checks issued, not recorded

19 Qualified person tracks retirement?

19. Retirement obligations incorrect

20. Actuary employed? Assumptions reviewed?

20. Retirement amounts incorrect

21. Cost records reconciled to payroll?

21. Incomplete accounting—usually cost records not complete

22. Periodic audit of payroll by internal auditors?

22. Undetected errors and frauds (all of the above)

23. Reconciliation with tax reports?

23. Over/underreporting

24. Classification instructions?

24. Misclassified debits in accounts

25. Review by accounting officer?

25. Accounting and classification errors

b. Preventive controls: 1, 2, 3, 4, 6, 7, 8, 9, 10, 12, 14, 15, 17, 19, 23 Detective controls: 5, 11, 13,16,18, 20, 21, 22, 24, 25

5.63

5.64

Role of a Board of Directors in Internal Control a.

Performing this role is very difficult for a board that meets once a month. The board can review budgeted to actual expenditures to control and monitor the necessity and reasonableness of costs. A written policy should be developed requiring the board chair or designee to review the expenditures incurred by the CEO. An annual formal orientation for new and returning board members conducted by the board attorney would ensure that there is an understanding of their purpose and responsibilities.

The board should implement an organizational structure that will allow it to receive and investigate anonymous concerns from its employees, vendors, and the general public. The board should also consider the creation of an internal audit function to report directly to the board. It should require detail related to travel, entertainment, and marketing expenditures so that board members are more aware of the expenditures incurred through the use of credit cards or employee reimbursements. The board‘s policies should inform its employees of any law that protects them from retaliation for reporting violations to certain authorities. The board should ensure that its meeting minutes adequately reflect all official board actions and a detailed reporting of its subcommittee meetings. The minutes should contain a detailed discussion of costs related to significant events and its administrative activities as well as any discussion among its members relating to budgetary issues or concerns. The board should also ensure a strict adherence to laws on closed sessions. It should plan and coordinate necessary travel trips in advance and incorporate the costs within the training and travel annual budget calculations. Any additional travel as well as the anticipated cost and attendee needs should be discussed at the board meeting so that the board‘s approval will be documented. Each type of benefit provided to an employee should be clearly identified by the board.

It all depends on the materiality level for the external auditors. If the expense amounts are above the materiality level, it is absolutely reasonable to expect the external auditors to detect this type of fraudulent activity. However, if the amounts are below the materiality level, the only way such activity will be detected is if one or more of these items were selected as part of their sample to test this type of expense amount. In addition, it is possible that auditors would select one or more of these items when testing control procedures. Importantly, if an item is selected for testing, the auditor should reasonably be expected to detect this type of fraudulent activity.

The board should review the need for credit cards and, if needed, should develop a policy on the use of credit cards and the review procedures that should be required of directors as well as board members. All reimbursement requests made by employees or board members for gifts or entertainment should be documented in a detailed manner with a description of why the business expense is directly related to the business.

IDEA Assignment – Authorization of Credit Tests of Controls 1-135 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. There were 14 customers with credit granted who are not on the master list. Please see the IDEA Workbook pages 80-87 for detailed solutions. b. Two customers have exceeded their credit limit. Please see the IDEA Workbook pages 88-89 for detailed solution. c. Control risk related to the authorization of credit is elevated, which will lead to increased risk of material misstatement with the valuation of A/R and completeness of the allowance for doubtful accounts and bad debt expense. 5.65

IDEA Assignment – Identifying Payments To Unauthorized Suppliers

a. 1. Please see the IDEA Workbook pages 169-175 for detailed solutions. b. $501,516. Please see the IDEA Workbook pages 169-175 for detailed solutions. c. As a result of these tests, control risk related to the authorization of purchases is elevated. The accounts most affected by this are the occurrence of purchases and rights & obligations related to accounts payable. CHAPTER 06 Employee Fraud and the Audit of Cash LEARNING OBJECTIVES

Review Checkpoints

26. Define and explain the differences among several kinds of employee fraud that might occur at an audit client. 27. Identify and explain the three conditions (i.e., the fraud triangle) that often exist when a fraud occurs. 28. Describe techniques that can be used to prevent employee fraud. 29. Identify the relevant assertions and risks of material misstatement that are typically related to the cash balance. 30. Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion related to cash and to help prevent or detect employee fraud. 31. Give examples of substantive procedures used to test cash and relate them to the relevant assertions.

Multiple Choice

Exercises, Problems, and Simulations

1, 2

27, 34

52, 56

3, 4, 5, 6

20, 24, 39, 43

56, 47

7, 8

21, 22, 23, 25

9, 10

31, 32, 33, 36

11, 12, 13, 14

26, 28, 29, 30, 35, 38

44, 45, 46, 51

15, 16

48, 49, 59

32. Describe some extended procedures for detecting employee fraud schemes involving cash.

17, 18

40, 41, 42

50, 51, 52, 53, 54, 58, 59

SOLUTIONS FOR REVIEW CHECKPOINTS 6.1

Employee fraud is the use of fraudulent means to take money or other property from an employer. The defining characteristics are (1) the fraudulent act, (2) the conversion of the money or property to the fraudster‘s use, and (3) the cover up. Embezzlement is a type of fraud by employees or nonemployees. Its defining characteristic is wrongfully taking money or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and cover up.

6.2

Fraud perpetrators look like other people, hence the difficulty in spotting them easily. However, for most people, committing a fraudulent act is stressful. Observation of changes in a person‘s‘ habits and lifestyles may reveal some red flags such as:

• Drinking too much. • Taking drugs. • Becoming irritable easily. • Being unable to relax, to sleep. • Becoming defensive, argumentative. • Being unable to look people in the eye. • Sweating excessively. • Going to confession (e.g., priest, psychiatrist). • Finding excuses and scapegoats for mistakes. • Working standing up. • Working alone. • Working late frequently. Personality red flags are difficult because (1) honest people often show them as well, (2) they often are hidden from view, and (3) auditors are not in a good position to notice these characteristics. However, auditors need to do the best they can to catch a fraudster. 6.3 A number of pressures/motivations might lead an honest person to commit fraud: Egocentric pressures/motivations  

My father was wealthy, and I need to be wealthy too. My friends admire cars, and I need to have an expensive one.

Ideological pressures/motivations  

Because the company sells tobacco and alcohol, it doesn‘t deserve to make a profit. I can award the government housing grants to best use without the HUD red tape. (Justifying diversion of funds in government housing programs.)

Economic pressures/motivations I need to:  Pay college tuition.  Pay hospital bills for my parent with cancer.  Pay gambling debts.  Buy drugs.  Pay alimony and child support.  Pay for high life style (homes, cars, boats).  Finance business or stock speculation losses.  Report good financial results. 6.4

A number of conditions might provide the opportunity for employee fraud, for example:       

6.5

Nobody counts the inventory, so losses are not known for certain. The petty cash box is often left unattended. Supervisors set a bad example by taking supplies home. Upper management considered a written statement of ethics but decided not to publish or circulate one to employees. Another employee was caught and fired but was never prosecuted. The finance vice president has investment authority without any review. Frequent emergency jobs leave a lot of excess material just lying around the plant.

A number of conditions might provide the rationalization for employee fraud, for example:      

―I need it more than the other person‖ (Robin Hood theory). ―I‘m borrowing the money and will pay it back.‖ ―Nobody will get hurt.‖ ―The company is big enough to afford it.‖ ―A successful image is the name of the game.‖ ―Everybody is doing it.‖

6.6

Some auditors look at capability as a fourth item necessary for committing a fraud. They argue that if a control weakness exists, but an individual does not have the skills and knowledge to take advantage of the weakness, an opportunity is not really present. Others would argue that these are separate issues and the opportunity exists whether the potential fraudster has the capability or not. This issue remains open and up for debate.

6.7

The cover-up or concealment of a fraud is a distinguishing attribute of a fraud. Often the audit team‘s first indication of a fraud is the identification of a control violation. Cover-up attempts generally appear in the accounting records. The key for an auditor is to be aware of and notice exceptions and oddities such as the following:

•

Unusual (either large or small) number or dollar amount of transactions.

•

Transactions for ―round‖ dollar amounts (e.g., $50,000).

•

Transactions recorded at unusual times of the day, month, or year.

•

Transactions associated with unusual branches or locations of a multilocation entity.

•

Cash shortages and overages.

•

Excessive voids and credit memos.

•

General ledgers that do not balance.

•

Increase in past due receivables.

•

Inventory shortages.

•

Unexplained adjustments to inventory or accounts receivable balances, especially without support.

•

Increased scrap or waste in a manufacturing plant.

•

Alterations on official documents.

•

Duplicate payments made to the same vendor.

•

Employees who cannot be found.

•

Use of copies instead of originals for supporting documentation.

•

Missing documentation to support transactions.

•

Unusual endorsements on checks.

•

Unusual patterns in deposits in transit.

•

Common names or addresses for refunds.

6.8

If Eloise Garfunkle is a company employee, somehow she cashed a check payable to a supplier. Maybe she is related to the supplier, or maybe she intercepted the check before it reached the supplier. The auditor may want to investigate further. Somebody is working on holidays! These dates—New Year‘s Day, Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas day—are normal days off for most businesses. A key question to consider is whether an auditor would have been able to identify holidays like Memorial Day and Labor Day if the other more obvious ones had not been listed

6.9

Since clients typically do not receive checks back from the bank, auditors can no longer use traditional clues from the back of the check (such as endorsements, amounts not matching front and back, erasure marks, etc.) Often the alteration of checks can only be discovered through selection of a check in tests of controls and noting that the amount on the check does not match to supporting documentation. Note that banks rarely scan and provide a copy of the reverse side of a check.

6.10

On this bank statement, only three clues indicate that the statement may have been altered:   

The auditor should always foot statements and the ending balance does not equal beginning + deposits - withdrawals. The low balance is $2,374.93 (the correct balance) and no transactions occurred after this point. There is a space for a gap in the check sequence, but no ―**‖‗s as with the other gaps.



The ―7‖ in $7,374.93 appears in a different font.

An auditor can also scrutinize other parts of the bank statement for reasonableness. For example, the number and dollar amount of deposits and checks can be compared to the detail data on the bank statement, the mathematical accuracy of the statement can be checked, and the statement itself can be studied for alterations. 6.11

In a cash collection process, someone will have to receive the cash and checks and thus has custody of the physical cash for at least a short period of time. Because this initial custody cannot be avoided, it is always a good control to (1) have two people open the mail containing customer receipts if possible, resulting in joint custody, (2) restrictively endorse the checks immediately after removing them from the envelope, (3) prepare a list of the cash receipts as early in the process as possible, and then (4) separate the actual cash from the record-keeping documents. The cash should be sent to the cashier or treasurer‘s office where a bank deposit is prepared and the money is sent to the bank daily and intact (no money should be withheld from the deposit). The list or remittance advices go to the accountants (controller‘s office), who then would record the cash receipts.

6.12

The accountant who records cash receipts and makes credits to customer accounts should never actually handle the cash. Rather, the accountant should receive a remittance list or remittance advice to make the entries to the cash and accounts receivable control accounts and to the customers‘ accounts receivable subsidiary account records. An accountant who had custody of the cash and made the entries to the different accounts could steal and then conceal their theft. This would be a violation of the segregation of duties. This is why the accountant should not perform both functions. In fact, a good additional internal control activity is to have control account and subsidiary account entries made by different people so that later the accounts receivable entries and balances can be compared (reconciled) to determine whether they agree in total. So, while it might be easier just to send the cash to the accounts receivable accountants, a dishonest accountant could steal cash while still giving the customer credit.

6.13

The word lapping refers to an employee‘s stealing the cash receipts of a company from a particular customer (Customer A) and then covering the amount with a following day‘s payment received for another customer‘s account (Customer B). In essence, the amount of money received from Customer B is applied to Customer A‘s account. This type of activity continues because when a check comes from Customer C, the employee would apply those funds to Customer B, etc. A lapping operation is possible when a single employee has access to both cash and accounts receivable records. The auditor is alerted to the possibility of a lapping operation when duties are not properly separated. Surprise confirmation is the primary means that an auditor can use to uncover such activity. Also, to detect this type of lapping scheme, a detailed audit should include comparison of the checks listed on a sample of deposit slips (from say Customer B) to the detail of customer remittances recorded to customer accounts (Customer A). Doing so is an attempt to find credits given to customers for whom no payments were received on the day in question. It can be hard to detect. However, detailed scrutiny will allow the auditor to catch the fraudster.

6.14

All vendors should be required to be on an approved vendor list. Vendors are placed on this list with approval from multiple departments (e.g. purchasing, engineering, and quality control). In addition, payments should not be made without a complete voucher package including a purchase order and receiving report. Because fictitious vendors do not supply product or service, such a fraud would require collusion between purchasing and receiving. As a result, having an approved vendor list would help to prevent a fraud.

6.15

A bank reconciliation tests for compatibility between the balance according to the financial statements, often referred to as ―books‖ and the bank balance obtained from a bank statement. The bank reconciliation should be performed by someone with no access to the cash, preferably in the accounting department. The bank reconciliation should be prepared monthly and reviewed by management in a timely manner. The auditor will test the bank reconciliation to provide evidence not only about internal controls, but also to substantiate the cash balances in the general ledger. 1-141 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6.16

A proof of cash can reveal unrecorded cash deposit and cash payment transactions when the deposits and payments reported by the bank are compared to the deposits and payments recorded in the general ledger and will require consideration of unrecorded amounts. Inspection of the bank statement and comparison to the general ledger (books) will uncover the problem provided the documents have not been destroyed.

6.17

Extended procedures are used as ―specific responses to identified fraud risk factors.‖ These audit procedures are performed only when the audit team thinks that an area deserves focused investigation given the facts and circumstances. In some cases, they are more complicated and expensive than normal audit procedures, and they usually involve a suspicion of something fraudulent occurring.

6.18

An auditor would use net worth analysis when fraud has been discovered or is strongly suspected, and the information to calculate a suspect‘s net worth can be obtained (e.g., asset and liability records, bank accounts). The method is to calculate the suspect‘s net worth (known assets – known liabilities) at the beginning and end of a period (months or years) and then to try to account for the difference as (1) known income less living expenses and (2) unidentified difference. The unidentified difference may be the best available approximation of the amount of a theft. Expenditure analysis is similar to net worth analysis except the data involve the suspect‘s spending for all purposes compared to known income. If spending exceeds legitimate and explainable income, the difference may be the amount of a theft.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 6.19

6.20

Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

Risk is high when the company always estimates the inventory but never takes a complete physical count. Risk is low when the petty cash box is always locked in the desk of the custodian. Risk is low when management has published a company code of ethics and sends frequent communication newsletters about it. Risk is low when the board of directors reviews and approves all investment transactions. An airtight control system of checks and supervision is not possible because of collusion and management override. This is a positive step but not the best long-run way to stop fraud. Dedicated ―hotline‖ telephones are a great idea, but you wouldn‘t want to put them on walls around the workplace where anonymity is impaired. Since ―people‖ are essential to a fraud prevention program, Practice management ―of the people and for the people‖ to help them share personal and professional problems is the best long-run way to stop fraud.

6.21

6.22

6.23

6.24

6.25

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Problems due to debt, addictions, or family problems motivate employees to commit frauds. Establishing an employee assistance program addresses these issues and ultimately may reduce the motivation to commit fraud for some employees. A fidelity bond reduces the risk to the employer for theft because this is a form of insurance. It also provides a background check on employees. Neither of these issues addresses the fundamental issue of employee motivation. Reconciliations are methods of detecting problems that have occurred. While these are good controls and may reduce the opportunities for employees to steal, reconciliations do not address employee motivation to commit fraud. Audits may detect fraud and even provide deterrence for fraud, but they do not address the employees‘ motivation to commit fraud. An appointment of a chief ethics officer would increase the effectiveness of the code of ethics. A hot line that allowed employees to report ethical violations would increase the effectiveness of the code of ethics. The violation of the code of ethics by senior management would reduce the effectiveness of the code of ethics because the tone at the top would send the wrong message to employees that the code of ethics was not important. The posting of the code of ethics and any other means of presenting the code of ethics to employees in the workplace would increase the effectiveness of the code of ethics. Numerous cash refunds made to different people at the same post office box address is an indicator of cash refund fraud. Internal auditor cannot locate several credit memos to support reductions of customers‘ balances is an indicator of accounts receivable fraud especially if there is not an appropriate separation of duties. Bank reconciliations that do not have outstanding checks or deposits older than 15 days are generally positive signs and are not indicative of fraudulent activity. Three people were absent the day the auditors handed out the paychecks and have not picked them up four weeks later is an indicator of ―ghost employees‖ (payroll fraud). Confirmation of cash balances provides the best evidence of the existence of cash held by a bank. Although a confirmation can provide evidence related to completeness, this is not the primary assertion auditors are concerned about in audits of cash. Valuation of cash is generally not a primary assertion for cash held with U.S. banks. Presentation and Disclosure is not an assertion that is supported through the confirmation of account balances. Electronic confirmations are often responded to in a much more timely manner because there are not mail delays. The evidence provided by an electronic confirmation is not greater than an manual confirmation presuming reliability of both methods. Prior to relying on confirmations from any source, auditors must obtain evidence supporting the reliability of the confirmation process. The authenticity of the confirmation is the primary advantage of using electronic confirmation. Unlike manual confirmations, electronic confirmations require usernames and passwords to access and complete the confirmation.

6.26

6.27

6.28

6.29

6.30

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Inventory should be counted on a regular basis; therefore, the fraud would be detected. Expense accounts are often good places to hide fraud because accounts are closed at the end of the year. Wage expense accounts may be compared to budget and may be reviewed by department managers that might detect the fraud. Expense accounts are often good places to hide fraud because accounts are closed at the end of the year. Consulting expense is a particularly good place to hide a fraud because it provides no actual product that may be counted or compared to the expense. Property tax expenses would likely be compared to the property tax bill and any discrepancies investigated. The inventory warehouse manager could steal inventory and then manipulate the records to cover up the theft. This arrangement would violate proper segregation of duties because the manager has custody of assets and access to the records. The manager can steal and then conceal! The cashier prepared the bank deposit, endorsed the checks with a company stamp, and took the cash and checks to the bank for deposit (no other bookkeeping duties). The cashier might steal currency but needs access to the records to cover up a theft of customer payments. To make entries in the customers‘ accounts receivable subsidiary accounts, the accounts receivable clerk received a list of payments received by the cashier. Good arrangement because the bookkeeper does not have access to cash. The financial vice president received checks made out to suppliers and the supporting invoices, signed the checks, and put them in the mail to the payees. Fraud would be difficult because financial VP would also need to be able to create fictitious vendors and invoices. The individual responsible for receiving the remittances is often responsible for preparing the daily deposit. Both activities qualify as ―custody‖ activities. So, this response is incorrect. The individual responsible for receiving the remittances is often responsible for making the daily deposit. Both activities qualify as ―custody‖ activities. So, this response is incorrect. The auditor would consider it incompatible because the cashier would have both custody of cash and record-keeping responsibility and, hence, could steal money and fix the records without interference by anyone else. The cashier could steal and then conceal! The individual responsible for receiving the remittances is often responsible for endorsing the checks. Both activities would qualify as ―custody‖ activities. So, this response is incorrect. Kiting involves a mismatching of dates of recording cash transactions around year-end. This procedure would not help the auditor detect kiting. Kiting involves a mismatching of dates of recording cash transactions around year-end. This procedure would not help the auditor detect kiting. Kiting involves a mismatching of dates of recording cash transactions around year-end, and the schedule of bank transfers is designed to show all the relevant dates so the auditor can see that the entries were made in the proper periods. Kiting involves a mismatching of dates of recording cash transactions around year-end. This procedure would not help the auditor detect kiting. The individual responsible for receiving the cash should not have access to the accounting records. This would violate proper segregation of duties. Thus, this is incorrect.

6.31

6.32

6.33

6.34

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Effective control of cash requires that receipts be recorded promptly. For mail receipts, a listing of remittance advices by an employee not performing incompatible functions is a standard control activity. If the customer does not return the remittance advice, one should be prepared at the time the mail is opened. If remittance advices are not used, a list of receipts should still be made when the mail is opened. The individual responsible for receiving the cash should not have access to the accounting records. This would violate proper segregation of duties. Thus, this is incorrect. While this is a step that would likely be completed by the individual receiving the checks, it is not the immediate step to be taken. Thus, this response is not the best answer and is incorrect. A check returned for insufficient funds would make the balance per bank different than the balance per books and would need to be reconciled. It would not change any of the information that was provided to the assistant controller. If the cash received was not deposited intact or remittances were not posted, the deposit slip amount would not match the remittances or the payments recorded. Controls over unauthorized access to accounts receivable strengthens the control indicated in the question because information on the payment report would be more reliable. The assistant controller would not be able to determine whether the payments were posted to the correct customer account with this information. Proper internal controls dictate that the remittance list is forwarded to the accounts receivable bookkeeper to ensure that each customer‘s balance is properly updated. This step does not involve internal auditors. Thus, this response is incorrect. Proper internal controls dictate that the remittance list is forwarded to the accounts receivable bookkeeper to ensure that each customer‘s balance is properly updated. This step does not involve the treasurer‘s office. Thus, this response is incorrect. The individuals with record-keeping responsibility should not have custody of cash. Hence, those individuals should use either the remittance advices or a list of the remittances to make entries to the cash and accounts receivable control account and to the subsidiary accounts receivable records. Indeed, having different people make entries in the control account and in the subsidiary records is an effective control. Proper internal controls dictate that the remittance list is forwarded to the accounts receivable bookkeeper to ensure that each customer‘s balance is properly updated. This step does not involve the entity‘s bank. Thus, this response is incorrect. Not recording sales on account in the books of original entry is the most effective way to conceal a subsequent theft of cash receipts. The accounts will be incomplete but balanced, and procedures applied to the accounting records will not detect the defalcation. Overstating the accounts receivable control account would make it easier for an auditor to detect the fraudulent activity. Thus, this response is incorrect. Overstating the accounts receivable subsidiary ledger would make it easier for an auditor to detect the fraudulent activity. Thus, this response is incorrect. Overstating the sales journal would make it easier for an auditor to detect the fraudulent activity. Thus, this response is incorrect. The definition of embezzlement involves property that is entrusted to the employee‘s control (as in d). This statement refers to larceny.

6.35

6.36

6.37

6.38

6.39

b. c. d.

Incorrect Incorrect Correct

This statement is similar to the definition of management fraud. This statement is similar to a mere error in accounting. This statement is the textbook and criminological definition of embezzlement.

Incorrect

Correct

Incorrect

It is not likely that an officer of the company would have the time to sign all checks. In addition, the final review of supporting documentation by the treasurer is a better answer to this question. Thus, this response is incorrect. A final review by the treasurer can catch mistakes made in the processing of the payment. This also involves a review of the supporting documentation, an important consideration as well. It is not likely that a company would ever require the internal auditors to account for all signed checks. In addition, the final review of supporting documentation by the treasurer is a better answer to this question. Thus, this response is incorrect. While this may be a worthwhile activity conducted by the entity‘s bank, it is not a control that would best protect against improper cash disbursements. Thus, this response is incorrect.

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

The existence of cash is always a relevant assertion for cash because an overstatement of cash might indicate that fraudulent revenue was recorded. It is possible that a firm could borrow money to include in a cash count and, therefore, not have the rights to the cash. However, such a scheme is of less concern then if the company claimed cash that did not exist. Because the value of cash is easily countable, this assertion is usually not an issue Improper cash presentation is of lower risk than the existence of cash . Because the sources and use of cash can vary greatly from year to year, balances in prior year are of little use. Management inquiry would provide poor information for use in performing analytical procedures. Budgets provided by management provide the best management estimates for the sources and uses of cash. Where cash receipts or cash expenditures vary from the budget by a material amount, a higher level of risk may be assessed. Failure to collect accounts receivable may indicate a problem with cash sources but would be only one part of an estimate of cash . The individual preparing the voucher package should not also be responsible for signing the checks. It is best to separate the authorization function from the custody function. Thus, this is not the correct response. Approval by two management officials would not necessarily prevent a voucher from being presented for payment twice. Thus, this is not the correct response. The alignment between the date on a voucher and when it is presented for payment would not necessarily prevent a voucher from being presented for payment twice. Thus, this is not the correct response. Cancellation of vouchers by stamping them PAID prevents the voucher from mistakenly being paid a second time. This is a correct response. However, since response (b) and response (c) are also correct responses, the answer to this question is response (d) which is all of the above. This is a correct response. However, since response (a) and response (c) are also correct responses, the answer to this question is response (d) which is all of the above.

6.40

6.41

6.42

6.43

Incorrect

Correct

Incorrect

Correct

d. e.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

Incorrect

This is a correct response. However, since response (a) and response (b) are also correct responses; the answer to this question is response (d) which is all of the above. The three factors that are likely to be present when fraud occurs are opportunity, motive, and the rationalization, which are reflected in responses (a-c). This is a step that the auditor would likely complete during the planning stages of the audit. In this situation, since the auditor believes that a discovered misstatement is or might be intentional, he/she should first perform additional procedures to obtain additional evidence to determine whether fraud has occurred, which is response (c). This is a step that the auditor would likely complete when completing the required communication with the audit committee that would occur after the auditor determined that a fraud had occurred. This would be an important step that would help the client prevent frauds in the future. Since the auditor believes that a discovered misstatement is or might be intentional, he/she should first perform additional procedures to obtain additional evidence to determine whether fraud has actually occurred. Response (c) is the correct answer. Response (c) is the correct answer. Obtaining more reliable information would be an appropriate modification to address assessed fraud risks. However, since response (b) and response (c) are also correct responses, the answer to this question is response (d) which is all of the above. Performing procedures closer to year end would be an appropriate modification to address assessed fraud risks. However, since response (a) and response (c) are also correct responses, the answer to this question is response (d) which is all of the above. Applying computer assisted auditing techniques to all data would be an appropriate modification to address assessed fraud risks. However, since response (a) and response (b) are also correct responses; the answer to this question is response (d) which is all of the above. All three responses reflected in (a-c) would be appropriate modifications to address assessed fraud risks. As a result, this is the correct response. Varying the timing of audit procedures would be an example of incorporating unpredictability into the selection of auditing procedures. As a result, this is not the correct response. Selecting items for testing that have lower amounts or are otherwise outside the scope of selection would be an example of incorporating unpredictability into the selection of auditing procedures. As a result, this is not the correct response. Performing auditing procedures on an unannounced basis would be an example of incorporating unpredictability into the selection of auditing procedures. As a result, this is not the correct response. Sending attorney letters to every attorney listed under the legal expense account is common as it is important for auditors to inquire about any possible loss contingency. Since it is a customary procedure, this would not be an example of incorporating unpredictability into the selection of auditing procedures and would be the correct answer. Since response (d) is the correct answer, this response is incorrect. An incentive or pressure to perpetrate fraud is a correct response. However, since (II) and (III) are also correct responses, the correct answer is letter (e).

Incorrect

Correct

An incentive or pressure to perpetrate fraud is a correct response. In addition, an opportunity to carry out the fraud is a correct response. However, since (III) is also a correct response, the correct answer is letter (e). An opportunity to carry out the fraud is a correct response. In addition, an attitude or rationalization that justifies the fraudulent action is a correct response. However, since (I) is also a correct response, the correct answer is letter (e). An incentive or pressure to perpetrate fraud is a correct response. In addition, an opportunity to carry out the fraud is a correct response. Finally, an attitude or rationalization that justifies the fraudulent action is a correct response. As a result, this answer is incorrect. An incentive or pressure to perpetrate fraud is a correct response. In addition, an opportunity to carry out the fraud is a correct response. Finally, an attitude or rationalization that justifies the fraudulent action is a correct response. As a result, this answer is correct.

SOLUTIONS TO PROBLEMS, EXERCISES AND SIMULATIONS 6.44

Tests of Controls over Cash Disbursements NOTES TO INSTRUCTOR: Procedure 2 is designed to indicate that work on one sample of cash disbursements can produce evidence related to several objectives. The tasks numbered 2a through 2l all relate to the number 2 sample items. TEST OF CONTROLS AUDIT PROCEDURES – A SAMPLE ANSWER Management Assertion

Test of Controls Procedure

Occurrence assertion Recorded disbursements are valid, authorized, and documented, representing payment for goods and services that were received.

1. Observe who has custody of signed checks for evidence of separation of duties from persons having cash disbursement or accounts payable record-keeping responsibilities and from persons who have cash disbursement authorization responsibilities.

Occurrence assertion Recorded disbursements are valid and documented, representing payment for goods and services received.

2. Select a sample of cash disbursements recorded during the period and 2a. 2b. 2c. 2d.

Compare to the canceled check. Examine for authorized signature and proper endorsement matching payee name. Compare recorded amount and check amount. Compare recorded payee name and name on check.

3. Scan the recorded cash disbursements for large or unusual amounts and perform the same work on these items as in sample 2. 2e.

e assertion Cash disbursements are authorized according to company policy.

2f. 2g. 2h.

assertion Cash disbursement dollar amounts are calculated and recorded accurately.

2i.

Examine supporting documents for a proper authorizing signature or initials approving the amount for payment. Trace authorizing signature to the list of authorized approvers. Trace vendor‘s name to approved vendor list. Recalculate amounts shown on the supporting vendor‘s invoices and compare to check amount. Recalculate cash discount, if any.

ion assertion Cash disbursements are properly classified in the accounts.

4. Obtain a chart of accounts and the accounting manual pertaining to classification policy. 2j. For each disbursement, determine whether the debit entry is classified accurately. 5. Foot selected summaries (daily, monthly) of cash disbursements.

ess assertion Cash disbursements accounting is complete: properly summarized and posted in the general ledger.

ertion Cash disbursements are recorded in the proper period.

6.45

6. Trace these totals to the general ledger debit and credit entries. 7. Foot the general ledger cash account.

8. Observe cash disbursement procedures and inquire to find out whether checks are held for a time before mailing. 2k. Compare date on check to date of recorded disbursement. 2l. Compare dates to payee‘s bank clearance date for any apparent lengthy delay that indicates that checks are held before mailing.

Internal Control Questionnaire for Book Buy-Back Cash Fund University Books, Incorporated REVOLVING CASH FUND INTERNAL CONTROL QUESTIONNAIRE—SAMPLE ANSWER

Question Is responsibility for the fund vested in one person?

Is physical access to the fund denied to all others?

Is the custodian independent of other employees who handle cash?

Is the custodian bonded?

Is the custodian denied access to other cash funds?

Are receipts unalterable?

Are receipts prenumbered?

Is the integrity of the prenumbered sequence periodically accounted for? Does the seller sign receipts?

Yes

10. Are receipts attached to reimbursement vouchers? 11. Are vouchers that are submitted for reimbursement approved by someone other than the custodian? 12. Are reimbursement vouchers and attachments (receipts) canceled after reimbursement? 13. Is the fund used exclusively for the acquisition of books? 1-149 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14. Is the fund periodically counted and reconciled by someone other than the custodian? 15. Is the fund maintained on an imprest basis? 16. Is the size of the fund appropriate for the purpose intended?

6.46

Test of Controls over Cash Receipts Other Audit Procedures

Reason for Other Audit Procedures

Source of debit entries in general ledger cash account other than from cash receipts journal should be investigated and supporting documents examined.

A surprise examination of cash receipts should be performed. Prior to the accounts receivable clerk obtaining the cash receipts, the auditor should make a list of them without the clerk‘s knowledge. The undeposited mail receipts should then be examined after their preparation for deposit and postings have been made to the subsidiary accounts receivable ledger. The deposit slip should be compared to the remittances for accuracy and totaled. Individual items on the deposit slip should be compared to postings to the subsidiary accounts receivable ledger. The auditor should then supervise the mailing of the deposit to the bank. The auditor should ask Gutzler to ask the bank to send the statement containing this deposit directly to the auditor. Postings from the deposit slips should be traced to the subsidiary accounts receivable ledger. Also, entries in the subsidiary accounts ledger should be traced to deposit slips.

Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity (consistently late payments). If Gutzler allows customers to take discounts, the amount of such discounts and the discount period should be checked.

Because there is no separation of duties between cash receipts and accounts receivables. the account receivable clerk may have appropriated discounts that could have been but were not taken or may have been careless in checking the appropriateness of discounts taken.

Dates and amounts of daily deposits per bank statement should be compared with entries in the cash receipts journal.

Because no initial controls over cash receipts were established prior to the time the accounts receivable clerk obtains the cash, the clerk may have become careless about prompt deposit of the daily receipts.

Because only the cash receipts journal was examined using standard procedures, the auditor must investigate the occurrence of all other sources of cash receipts that are not recorded in these journals. Because there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, a surprise examination is the only method of determining whether cash receipts are being recorded and deposited correctly.

Because there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have been careless in performing the posting duties. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. See the preceding answer.

6.47

A proof of cash working paper that reconciles total cash receipts with credits per bank statement should be prepared.

For those periods for which the preceding audit procedures were not performed and for a period after the balance sheet date, scan the cash receipts journal and bank statements for unusual items.

Because internal control over cash receipts is weak, the auditor should perform this overall check to help substantiate that all material items were investigated during the performance of the detail tests. Because internal control over cash receipts is weak, the auditor should perform this review to help substantiate that all material items not covered during other tests were investigated.

Internal Control over Sales Returns a.

Employees can falsify returned goods (no goods were actually returned) and take the cash from the register as if it were provided to a customer.

Procedures that may prevent this type of fraud include: (1)

Having one employee authorize the return and have the customer take the authorization to a cash register to obtain the money.

(2)

Having management authorization for all returns.

Procedures that might detect this fraud include: (1) Performing analytical procedures, for example, comparing returns per employee or returns per shift. (2)

6.48

Contacting customers to ascertain the reason for returns. This may also act as fraud prevention if employees know that management may follow up with customers.

Performing analytical procedures might detect an increase in returns. Also, because returned goods should go back to inventory, inventory shortage may indicate that goods were not actually returned.

Procedures for Auditing a Client’s Bank Reconciliation a.

Identification of procedures: A. B. C. D. E. F.

Balance per bank: procedures 4 and 9 Deposits in transit: procedures 1, 7, 8, 9, and 10 Outstanding checks: procedures 2, 7, 8, 9, and 10 Customer note collected by the bank: procedure 5 Error: Check 1282, written on Sept 26: procedures 5 and 9 Balance per books: procedure 3

The total of outstanding checks is $13,480, not $11,450. Someone has manipulated the bank reconciliation to match the general ledger balance, which is overstated by $2,000 (provided the general ledger balance is $20,400.)

6.49

Manipulated Bank Reconciliation Yes, something is wrong, and it takes a careful eye to detect it. The bank statement has been altered. Cleared check 2233 for $5,000 has been erased, and the bank balance has been changed from $2,374.93 to $7,374.93. The bank balance is actually $5,000 lower than the reconciliation shows. Because the problem says ―all checks entered in Caulco‘s cash disbursements journal through February 29 have either cleared the bank or are listed as outstanding checks in the February bank reconciliation,‖ the conclusion is that this $5,000 check was not recorded. Students can find the alteration several ways. They can (1) notice the check (!) and find that it is not on the bank statement even though it is dated and cleared in February, (2) add the checks listed in the February bank statement and find that the total is $5,838.29, not the $10,838.29 shown on the bank statement, and the number of checks (25) does not match the bank statement (26), (3) add the previous balance to the deposit and subtract the withdrawals to find a balance of $2,374.93 instead of the altered $7,374.93, and (4) notice the skip in the numerical sequence not noted by the bank‘s double asterisk (**) used to indicate a skip (this is the place the paid check was erased). Also, the ―low bank balance‖ figure of $2,374.93 gives it away. CAULCO, INC. Bank Reconciliation (Corrected) February 28 Balance per bank ..............................................................................................

$ 2,374.93

Deposit in transit ..............................................................................................

1,097.69

Outstanding Checks: Number Date

Payee

Amount

2239 2240

Alpha Supply L.C. Statement

500.00 254.37

Feb 26 Feb 29 Total Outstanding

6.50

(754.37)

Reconciled balance General ledger balance Feb 28

$ 2,718.25 $ 7,718.25

Cash overstatement, Check 2233 not recorded

$ 5,000.00

Investigating a Fraud If the company is local, visit the location to determine whether the company exists. Obtain the checks used to pay the vendor to determine the bank used by the vendor (information should be on the back of the check). Match the vendor invoices to receiving reports to determine whether product was received. Match the invoices to purchase orders and purchase requisition to determine whether purchase orders exist and that material was requested. If purchase orders or requisitions come from the same person, check the bank used by that person (from the direct deposit information or the back of their paycheck) to see whether it is the same bank as the vendor (or maybe even the same account). Check the county court house for information on the business. Of course, depending on the facts and circumstances, other procedures may also be valid.

6.51

Fraud in Purchasing a.

It is likely that a purchasing agent has created a shell company (K. A. Supplies) and is awarding bids to it. Once the bid is awarded, someone purchases the necessary materials and sends them to Big Builders at a marked-up price.

6.52

We might obtain information about the bank account used by K. A. Suppliers. This information would be available on the back of the checks we used to pay K. A. Suppliers. We may wish to do an analysis of the business we do with K. A. Supplier.

The receipt and recording of bids may be segregated from the purchasing function. In addition, a requirement that all bids be attached to the purchase order may provide senior management in purchasing the opportunity to see that the lowest bid is the bid being accepted. The bidders should be required to be on the approved vendor list, and an inspection of the vendor facility by someone not in purchasing should be required before adding a company to the list.

The Perfect Crime? The ingenious scheme was a perfect crime for a long time. Only the greed of the embezzler finally tipped off the managers, who commissioned a special investigation to learn why expenses were high, profits low, and cash flow small. Ordinary everyday control activities for detection: •

• •

Someone else taking over the embezzler‘s duties at vacation time might have been less willing or able to dig out the documentation to support payment of ―past due‖ amounts, thus leading to suspicion and perhaps discovery. The embezzler avoided the problem by clearing all the vendor payments a month before his regular vacation. The treasurer might have been more diligent about remembering earlier payments of amounts later submitted as past due but had other more important assignments. (In fact, the documents were just scanned and the checks were signed with a mechanical signature plate). Someone in charge of investigating budget variances (when they occurred) might have been more in tune with ―thinking like a crook,‖ but several people in several departments were not that careful. The variances were not very large after the first two years (although some larger ones began to appear toward the end when the embezzler got greedy).

Extensive detection efforts: • • • •

•

6.53

The investigator spent a long time reviewing the expense accounts and studying documentation and noticed fairly frequent payments of past due balances. In the course of repeated interviews with the company president, the investigator learned about the company‘s policy of paying bills on time to obtain trade discounts. The president was surprised to learn of the numerous incidents of past due bills. Additional searching by the investigator led to noticing five ―quarterly payments‖ in an expense account for the rental of a photocopy machine. This was the first obvious sign of a duplicate payment. The investigator asked the bank to send copies of the checks for the five payments. One proved to be payable to the embezzler. This discovery led to requests for access to all the company‘s canceled checks, and the investigator then was able to find numerous checks payable to the embezzler. The physical differences in the company‘s own checks and the embezzler‘s private stock were small, but they were noticeable. Charges were filed. The district attorney subpoenaed the embezzler‘s bank account records, and the bogus checks were matched with deposits.

Select Effective Extended Procedures These procedures are offered without explanation of the information that might be discovered. For each one, a confirmation of the suspicion might arise. One definite instance is enough to justify proceeding with an investigation (real fraud examination), but failure to find confirming evidence can mean (1) nothing wrong is going on or (2) the crook is too clever for the auditor. All of these procedures should be conducted with care not to impugn falsely the integrity of the people under investigation. 1-153 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6.54

Count the petty cash fund on Friday morning in the presence of the supervisor and custodian of the fund. Then perform a surprise count Friday afternoon before the custodian leaves work for the day.

The auditor can ask the local Better Business Bureau for reports on the eight new vendors. The auditor can also ask the local Chamber of Commerce if they are members or can look them up in the telephone book. Telephone them and ask about business hours, product availability, and other matters, but not in a way to arouse suspicion of investigation. Visit the business location (telephone book address) to browse. Go to the local tax assessor-collector‘s office files to look up the owner of the property where the businesses are located. If any of the new vendors are professional people, look them up in state licensing agency directories (e.g. CPAs, attorneys, doctors). Go to the state secretary of state‘s office and look up the corporate charter to see whether the purchasing agent is shown as an incorporator, officer, or director (if a large company, you can use Standard & Poor‘s Register of Corporations, Directors, and Executives). The auditor can also look the eight new vendors up in the state or county ―assumed name‖ files for real names. Write a check to each business, and use the canceled check to identify the businesses‘ banks; then get one of the purchasing agent‘s canceled payroll checks to see whether they all bank at the same place. (This is circumstantial evidence that needs more work, but it would be an unlikely coincidence in most cases if all of them had accounts at the same bank.) Avoid approaching the chief purchasing agent with inquiries about the new vendor approval process because you might alert the person to the investigation.

Select the people who have quit and determine their termination dates. In the payroll records, find the identification of their last paychecks (check number) and then find the canceled checks and look for two endorsements, one of which might be the payroll supervisor. Contact the terminated employees on the pretext of an exit conversation, and inquire whether they received all their paychecks, being sure to identify the last period or severance pay provision for them.

Add the customers‘ subsidiary accounts and compare the amount to the general ledger control account. If clerks are giving customers proper credit in their subsidiary accounts but not depositing the money and enabling the accounting system to credit the control account, the accounts may be out of balance. If you can identify suspicious accounts, ask the customers to give you originals or copies of their canceled checks so you can examine the endorsements to see whether they appear to have been negotiated by a company employee.

Use the cash receipts journal date and the deposit date at the bank to see whether there is a pattern of delay that could indicate the cashier is holding the deposits. The last resort is a surprise cash count at the cashier‘s desk to see whether cash on hand is actually on hand.

Forensic Accounting: Assurance Engagement 1: Expenditure Analysis Forensic Accounting Consulting Engagement 1

Known expenditures: House payments Mercedes payments Nissan Maxima payments Audio and video equipment Household expenses

12 @ $ 1,377 12 @ $ 2,361 (down + monthly) 12 @ $900

Total estimated expenditures Known sources: Beginning bank balance Take-home pay 12 @ $2,950

$ 16,524 28,332 9,444 5,532 10,800 $70,632

$ 3,463 35,400

Ending bank balance Total known sources

(2,050) $ 36,813

Expenditures financed by unknown sources

6.55

$ 33,819

Forensic Accounting: Assurance Engagement 2: Net Worth Analysis Forensic Accounting Consulting Engagement 2 Year 1

Year 2

Year 3

$ 100,000 30,000 20,000 50,000 6,000

$ 100,000 30,000 20,000 50,000 12,000

$ 100,000 42,000 40,000 50,000 14,000

$ 206,000

$ 212,000

$ 246,000

90,000 10,000

50,000 0

0 0

Total liabilities

$ 100,000

$ 50,000

Net Worth

$ 106,000

$ 162,000

$ 246,000

Change in net worth Total expenses*

$ 56,000 30,800

$ 84,000 28,000

Increase in net worth + expenses

$ 86,800

$ 112,000

40,000

42,000

$ 46,800

$ 70,000

Assets: Residence Stocks and bonds Automobiles Certificate of deposit Cash Total assets Liabilities: Mortgage balance Auto loan

Known income Funds from unknown sources * Includes some principal payments on debts. 6.56

Employee Embezzlement via Cash Receipts and Payment of Personal Expenses a. In general, cash disbursements should be authorized by responsible officers of the organization to be for valid business purposes. It is not unusual for a business manager to have the authorization responsibility. Tight control would call for disbursement review (at time of check signature) by another responsible person (superintendent), and this control was not always observed. Cash receipts should be listed by the person initially in control (cafeteria manager), deposited by another person (business manager), and a responsible person (superintendent, internal auditor, external auditor) should compare the initial control record to the deposit to note any differences. b. There are a number of procedures that can be completed to obtain evidence about existing controls. The auditor may start the process with a series of inquiries. For example, being forewarned by the informant, the auditors could make inquiry: ―Does the school district have a fund for which individual disbursements are not approved by the school board?‖ and ―Does the business manager have responsibility for this fund?‖ Answers to both questions directed to the superintendent would be ―yes,‖ and the auditors can then concentrate initial attention on the particular account records. 1-155 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Further, the next question is: ―Does the cafeteria manager make a record of the daily receipts?‖ Answer by the superintendent: ―I don‘t know, ask her.‖ Luckily, it turned out that the cafeteria manager without direct instructions made notes on a calendar of the amount of money sent forward to the business manager for deposit. Thus, a concrete control test might be to compare the amounts from the cafeteria manager‘s calendar to the deposits in the account. c. In order to consider some procedures for gathering evidence in this case, it is important to remember that the balances being audited are the expense accounts that received the debits from the extra bank account. However, it is still efficient to go to the bank account records as a starting point for the investigation and then obtain the bank statements and supporting documents for cash disbursements. Study them for evidence of: (1) improperly authorized payments, (2) payments of personal expenses on the school district‘s VISA account, and (3) payments to unauthorized persons or to ―cash‖ for unauthorized purposes. d. Students answers will vary for this question. In reality, after finding payments to American Express and VISA, auditors asked the superintendent about the credit card used by the school and learned that the school uses only VISA. Inquiry at American Express revealed the business manager as the owner of the account number found on receipts in the supporting documents. (Actually, by this time, the business manager had confessed, but identification of the account might have been more difficult.) Study of the items and dates on the VISA charge slips showed items (e.g. hosiery) not used at the school and dates that did not match business periods. Review of the checks identified the son as payee on some of the checks. During this review, the auditors found checks dated out of numerical sequence and a missing block in the most current month. This was an indication of having blank checks signed, so the superintendent was asked, and he admitted doing so. The missing block was in the business manager‘s desk drawer, already signed. Comparing the cafeteria manager‘s notes of cash receipts showed shortages in numerous deposits. The business manager admitted taking the cash. 6.57

Electronic Confirmations NOTE TO INSTRUCTOR: For this assignment, students are required to visit Confirmation‘s educational website and watch a video.

6.58

Case of the Missing Petty Cash Based on the case information, the former petty cash custodian apparently had more expenditures than the new one. It is possible that the former one was running false expense claims through the fund. This is certainly a legitimate explanation for the difference and may be worth additional investigation.

6.59

The Laundry Money Skim Some examples of trying to ―think like a crook‖ include: 

Because there are no separation of the duties and responsibilities for (1) transaction authorization, (2) record keeping, (3) custody of or access to assets, and (4) reconciliation of actual assets to the accounting records, an employee could see an opportunity for fraud.



A supervisor doesn‘t take approval responsibilities seriously and fails to perform them (like the supervisor of the petty cash custodian in the text case).



An employee is aware that tight control may be too expensive and simply not performed (like the lack of observation of the laundry money collectors in the text case).



A payroll employee who has responsibility for preparing personnel files for new hires, approval of wages, verification of time cards, and distribution of payroll checks can ―hire‖ fictitious employees, fake their records, and order checks through the payroll system.

CHAPTER 07 Revenue and Collection Cycle LEARNING OBJECTIVES Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1. Describe the revenue and collection cycle, including typical source documents.

1, 2, 3, 4, 5

2. Identify significant accounts and relevant assertions related to the revenue and collection cycle.

6, 7, 8

3. Discuss the risk of material misstatement in the revenue and collection cycle, with a specific focus on improper revenue recognition.

9, 10, 11

34, 40, 42, 44, 58, 61, 62

72, 74

4. Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion in the revenue and collection cycle. 5. Give examples of tests of controls to test the operating effectiveness of internal controls in the revenue and collection cycle.

12, 13, 14

37, 38, 39, 50, 56, 59

64, 65, 69, 73

15, 16, 17, 18, 27

66, 71, 75, 78, 79

6. Give examples of substantive procedures in the revenue and collection cycle and relate them to assertions about significant account balances at the end of the period.

19, 20, 21, 22, 23, 24, 25 26

35, 41, 43, 45, 46, 47, 48, 49, 51, 53, 54, 57, 60, 63

67, 68, 70, 77, 80

7. Apply your knowledge to perform audit procedures in the revenue cycle and evaluate the findings of your tests.cycle and design some audit and investigation procedures for detecting them.

28, 29, 30, 31, 32

36, 52

77, 78, 79, 80, 81

SOLUTIONS FOR REVIEW CHECKPOINTS 7.1

The basic sequence of activities and accounting in a revenue and collection cycle is: a. b. c. d. e.

Receiving and processing customer orders. Entering data in an order system and obtaining a credit check. Delivering goods and services to customers. Authorizing release from storekeeping to shipping to customer. Entering shipping information in the accounting system. Billing customers, producing sales invoices. Accounting for accounts receivable. Collecting cash and depositing it in the bank. Accounting for cash receipts. Reconciling bank statements.

7.2

When documents such as sales orders, shipping documents, and sales invoices are prenumbered, someone can later account for the numerical sequence and determine whether any transactions have failed to be recorded. (Completeness assertion.)

7.3

Access to computer terminals should be restricted so that only authorized persons can enter or change transaction data. Access to master files is important because changes in them affect automatic computer controls, such as credit checking and accurate inventory pricing.

7.4

Auditors could examine these files for evidence of:   

7.5

7.6

Unrecorded sales — pending order master file, Inadequate credit checks — credit data/check files Incorrect product unit prices — price list master file

With a sample of customer accounts receivable: 

Find the support for debit entries in the sales journal file. Expect to find evidence (copy) of a sales invoice, shipping document, and customer order. The sales invoice indicates the shipping date.



Find the support for credit entries in the cash receipts journal file. Expect to find a remittance advice (entry on list), which corresponds to detail on a deposit slip, on a deposit actually in a bank statement for the day posted in the customers‘ accounts.

According to the professional standards, an account is significant and a financial statement assertion is relevant if it has a ―reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.‖

7.7 Occurrence of revenue is considered a significant account and relevant assertion for several reasons:  The magnitude of revenue is often substantial indicating that recorded revenues are generally material.  Management has an incentive to overstate revenues, thus the occurrence assertion is relevant.  Stakeholders focus on revenue as a performance measure, therefore the account is significant to users of the financial statements. 7.8

The inherent risk for the existence assertion for accounts receivable is often higher than inherent risk for the completeness assertion because management has an incentive to overstate accounts receivable. It is important to place emphasis on the existence assertion because auditors have often been sued for malpractice by providing unqualified reports on financial statements that overstated assets and revenues and understated expenses. For example, credit sales recorded too early (e.g., a fictitious sale) result in overstated accounts receivable and overstated sales revenue.

7.9

Revenue recognition refers to including revenue in the financial statements. According to GAAP, this is done when revenues are (1) realized or realizable and (2) earned.

7.10

Revenue recognition is used as a primary means for inflating profits for several reasons. First, it is not always straightforward when revenues have been earned. Sales can be structured with return provisions or can have other performance provisions attached. Second, the timing of shipments at year-end may be easy to falsify. Third, markets often value companies based on a multiple of its revenue instead of net income.

7.11

New companies often do not show a profit during their first few years. Therefore, creditors and investors often place more emphasis on the revenues, especially looking for revenue growth that might lead to future profitability. Knowing this, management could try to inflate revenues.

7.12

To ensure completeness of recorded revenue, all invoices, shipping documents, and sales orders should be prenumbered, and the numerical sequence should be checked on a timely basis.

7.13

In a standard revenue cycle, a three-way match of a customer purchase order, evidence of shipment (perhaps a bill of lading), and a customer invoice provides the best evidence of a completed sale. A company should generally not recognize revenue until all three documents are present. This control will provide assurance about the occurrence of revenues and the existence of accounts receivable.

7.14

Entity level controls provide an additional level of assurance for the auditor related to control risk. For example, if the client has a strong audit committee, this provides additional assurance that appropriate oversight is being conducted internally. Control risk assessment should always be conducted in a top-down approach, with entity level controls considered initially.

7.15

These specific control procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control system governing revenue recognition and cash collections:

7.16



No sales order should be entered without a customer order.



A credit-check code or manual signature should be recorded by an authorized person.



Access to inventory and the shipping area should be restricted to authorized persons.



Access to billing terminals and blank invoice forms should be restricted to authorized personnel.



Accountants should be instructed to record sales and accounts receivable when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received.



Customer invoices should be compared with bills of lading and customer orders to assure that the customer is sent the goods ordered at the proper location for the proper prices and that the quantity being billed is the same as the quantity shipped



Pending order files should be reviewed in a timely manner to avoid failure to bill the customer and record shipments



Bank statements should be reconciled in detail monthly. The purpose of the walkthrough is to obtain an understanding of the transaction flow, the control procedures, and the populations of documents that may be utilized in tests of controls. In a walkthrough of a sales transaction, auditors take a small sample (usually 1–3 items) of a sales transaction and trace it from the initial customer order through credit approval, billing, and delivery of goods to the entry in the sales journal and subsidiary accounts receivable records, and then its subsequent collection and cash deposit. 1-159 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Sample documents are collected, and employees in each department are questioned about their specific duties. The information gained from documents and employees can be compared to answers obtained on an internal control questionnaire to ensure proper procedures are taking place.

7.17

In general, the types of procedures in tests of controls over the operating effectiveness involve vouching, tracing, observing, scanning, reperforming and recalculating.

7.18

Dual direction tests of controls sampling refers to procedures that test file contents in two ―directions‖: the occurrence direction and the completeness direction. The occurrence direction involves a sample from the account balance (e.g., sales revenue) vouched to supporting sales and shipping documents for evidence of occurrence. The completeness direction is a sample from the population that represents all sales (e.g., shipping document files) traced to the sales journal or sales account for evidence that no transactions (shipments, sales) were omitted.

7.19

Accounts receivable is often the debit entry when Sales Revenue is recognized – particularly if the sale is being recognized fraudulently. In these cases, cash would not be received, so the fictitious balance would end up in accounts receivable. As a result, auditors are concerned about the validity or existence of accounts receivable. Note that auditors are also concerned about the valuation assertion for accounts receivable – just because someone owes a company money does not mean they will pay that amount.

7.20

These procedures are usually the most useful for auditing the existence assertion: Confirmation. Letters of confirmation asking for a report of the balances owed to the company can be sent to customers. Verbal Inquiry. Inquiries to management usually do not provide very convincing evidence about existence and ownership. However, inquiries about the company‘s agreements to pledge or sell with recourse accounts receivable in connection with financings should always be made. Examination of Documents (vouching). Evidence of existence can be obtained by examining shipping documents. Examination of loan documents may yield evidence of the need to disclose receivables pledged as loan collateral. Scanning. Assets are supposed to have debit balances. A computer can be used to scan large files of accounts receivable, inventory, and fixed assets for uncharacteristic credit balances. The names of debtors can be scanned for officers, directors, and related parties, amounts for which need to be reported separately or disclosed in the financial statements. Analytical Procedures. Comparisons of asset and revenue balances with recent history might help detect overstatements. Relationships such as receivables turnover, gross margin ratio, and sales/asset ratios can be compared to historical data and industry statistics for evidence of overall reasonableness. Account interrelationships also can be used in analytical review. For example, sales returns and allowances and sales commissions generally vary directly with dollar sales volume, bad debt expense usually varies directly with credit sales volume, and freight expense varies with the physical sales volume. Accounts receivable write-offs should be compared with earlier estimates of doubtful accounts.

7.21

Comparison of sales and accounts receivable to previous periods provides information about existence. Other useful analytical procedures include receivables turnover and days of sales in receivables, aging, gross margin ratio, and sales/asset ratios, which can be compared to historical data and industry statistics for evidence of overall reasonableness. Auditors may also compare sales to nonfinancial data such as units sold, number of customers, sales commissions, and so on. These comparisons can be made by product, period, geographic region, or salesperson.

7.22

A positive confirmation is a request for a response from an independent party whom the auditor has reason to expect is able to reply. A negative confirmation is a request for a response from the independent party 1-160 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

only if the information is disputed. Negative confirmations should be sent only if the recipient can be expected to detect an error and reply accordingly. They are normally used for accounts with small balances when control risk is low. 7.23

Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include (a) receivables are not material, (b) confirmations would be ineffective based on prior years‘ experience or knowledge that responses could be unreliable, and (c) analytical procedures and other substantive procedures provide sufficient, competent evidence.

7.24

Auditors need to take special care in examining sources of accounts receivable confirmation responses. Auditors need to control the confirmations, including the addresses to which they are sent. History is full of cases in which confirmations were mailed to company accomplices who had provided false responses. The auditors should carefully consider features of the reply such as postmarks, FAX, and email responses, letterhead, electronic mail, telephone number, or other characteristics that may give clues to indicate false responses. Auditors should follow up electronic and telephone responses to determine their origin (for example, returning the telephone call to a known number, looking up telephone numbers to determine addresses, or using a crisscross directory to determine the location of a respondent).

7.25

When positive confirmations are not returned, the auditor should perform the following procedures: a. Send second and even third requests. b. Examine subsequent cash receipts. c. Examine sales orders, invoices, and shipping documents. d. Examine correspondence files for past due accounts.

7.26

To determine the adequacy of the allowance for doubtful accounts, the auditor reviews subsequent cash receipts from the customer, discusses unpaid accounts with the credit manager, and examines the credit files. These should contain the customer‘s financial statements, credit reports, and correspondence between the client and the customer. Based on this evidence, the auditor estimates the likely amount of nonpayment for the customer, which is included in the estimate of the allowance for doubtful accounts. In addition, an allowance should be estimated for all other customers, perhaps as a percentage of the current accounts and a higher percentage of past due accounts. The auditor compares his or her estimate to the balance in the allowance account and proposes an adjusting entry for the difference.

7.27

Dual-direction testing involves selecting samples to obtain evidence about control over completeness in one direction and control over occurrence in the other direction. The completeness direction determines whether all transactions that occurred were recorded (none omitted), and the occurrence direction determines whether recorded transactions actually occurred (were valid). An example of the completeness direction is the examination of a sample of shipping documents (from the file of all shipping documents) to determine whether invoices were prepared and recorded. An example of the occurrence direction is the examination of a sample of sales invoices (from the file representing all recorded sales) to determine whether supporting shipping documents exist to verify the fact of an actual shipment. The content of each file is compared with the other.

7.28

In the Canny Cashier case, if someone other than the assistant controller had reconciled the bank statement and compared the details of bank deposit slips to cash remittance reports, the discrepancies could have been noted and followed up. The discrepancies were that customers and amounts on the bank deposit slips to cash remittance reports did not match.

7.29

To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, internal controls should ensure that receipts are recorded daily and are complete. A careful bank reconciliation by an independent person may detect such errors.

7.30

Confirmations to taxpayers who had actually paid their taxes would have produced exceptions, complaints, and people with their counter receipts. These results would have revealed the embezzlement.

7.31

Auditors might have obtained the following information: 1-161 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Inquiries: Personnel admitting the practices of backdating shipping documents in a ―bill-and-hold‖ tactic or personnel describing the 60-day wait for a special journal entry to record customer discounts taken. Tests of Controls: The sample of customer payment cash receipts would have shown no discount calculations and authorizations, leading to inquiries about the manner and timing of recording the discounts. Observation: When observing the physical inventory-taking, special notice should be taken of any goods on the premises but excluded from the inventory. These are often signs of sales recorded too early. Confirmations of Accounts Receivable: Customers who had not yet been given credit for their discounts can be expected to take exception to a balance that is too high. 7.32

The auditors would have known about the normal Friday closing of the books for weekly management reports, and they could have been alerted to the possibility that the accounting employees overlooked the once-a-year occurrence of the year-end date during the week.

SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS 7.33

Incorrect

Allowances can be made for anticipated returns if the earning process is substantially complete. The earning process is complete at this point. Under accrual accounting, the cash does not have to be collected, only collectible This is usually the method for determining (b.), but the shipment might be FOB destination

b. c.

Correct Incorrect

Incorrect

7.34

a. b. c. d.

Incorrect Incorrect Correct Incorrect

This only initiates the earnings process but it doesn‘t complete it. This is often the case, but it depends on shipping terms. This is often the same as the bill of lading date. Under accrual accounting, the company doesn‘t have to wait for the check to record revenue.

7.35

Incorrect

b. c. d.

Correct Incorrect Incorrect

This would not have the outstanding balance; however, there are some times when the auditor confirms the sale instead of the amount receivable. This would have the balance for confirming This would not have the individual customer balance This would not have the balance outstanding

7.36

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This is an essential part of the cycle. This is an essential part of the cycle. Cash is affected by the collections. Even though this involves shipments, it is considered part of the expenditure and disbursement cycle.

7.37

a. b. c. d.

Incorrect Incorrect Correct Incorrect

The sale could occur but not be approved for credit. The approval is unrelated to the completeness assertion. Credit approval helps ensure that the sale will be collectible. Credit approval will not affect in which period the revenue is earned.

7.38

a. b. c.

Incorrect Incorrect Correct

The general ledger bookkeeper doesn‘t have access to the customer accounts. There‘s no advantage to separating access to checks and currency. The cash is not in the same physical place as the employees; therefore it cannot be stolen.

Incorrect

Normally checks are made payable to company. That doesn‘t prevent lapping.

Correct

b. c. d.

Incorrect Incorrect Incorrect

Impropriety of write-offs can be controlled by the review and approval of someone outside the credit department. Even write-offs of old receivables can conceal a cash shortage. The cashier could be the cause of the shortage. Write-offs should be separated from the sales function.

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

7.41

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This doesn‘t verify that the sales invoices represent actual shipments. This would require tracing from shipping documents to invoices. This would require tracing from invoices to customer accounts. Vouching is used to establish support for recorded amounts.

7.42

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Unrecorded costs would not increase sales. Improper credit approvals would not lower COGS. Goods were shipped for these sales, and COGS as a percentage of sales would be unchanged. Improper sales cutoff would not decrease COGS as a percent of sales. Fictitious sales would increase sales. Because no actual product was shipped, COGS as a percent of sales would decrease. The most likely debit for fictitious sales is accounts receivable, causing accounts receivable to increase.

a. b.

Incorrect Correct

Incorrect

Correct

a. b. c.

Incorrect Incorrect Correct

7.39

7.40

7.43

7.44

7.45

This would increase gross profit. Less sales revenue and correct amount of cost of goods sold results in less gross profit, therefore the ratio of gross profit to sales will decrease. (Actually, the gross profit numerator will decrease at a greater rate than the sales denominator in the ratio, causing the ratio to decrease.) This would increase gross profit. This would increase sales and cost of sales, and the ratio would not change. If cost of sales is not recorded, gross profit would increase

Additional inquiries would not provide sufficient corroborating evidence. Reviewing the changes in pricing during the year and ensuring that customers were charged the new prices provides sufficient, reliable evidence to support the sales manager‘s representation. This is an ineffective use of confirmations and requires respondents to identify unit costs and report information. Payments on vendor invoices would not indicate that prices had increased during the year. When an account is recorded as a receivable, it is already recorded as a revenue. Adding additional revenue would not cover the theft of accounts receivable. Receiving money from petty cash would be a poor method to cover the theft of accounts receivable. The money in petty cash would have to be accounted for and is not likely to be sufficient to cover any significant amounts. Miscellaneous expense would raise suspicion because all miscellaneous accounts are high risk and subject to review. In addition, accounts receivable are usually not written off against an expense. Using the sales returns account would raise the least suspicion because this account is more commonly linked to accounts receivable. A bookkeeper could steal money and ―write off‖ to unsuspecting customer‘s balance with a fictitious ―sales return.‖ The payment is probably in transit. The shipment is probably in transit. This should have been recorded as a reduction or credit to the receivable by 12/31.

Incorrect

This occurred after the end of the period.

Incorrect

Correct

A schedule of purchases and payments would be used to test transactions and might be performed. Negative confirmations would not be an appropriate choice for large account balances The terms on the accounts receivable would not provide information on balance and transaction amounts The most likely audit step when there are a few large accounts is to send out positive confirmations.

7.47

a. b. c. d.

Incorrect Incorrect Correct Incorrect

The aged trial balance provides only indirect evidence about controls. The aged trial balance provides no evidence about accuracy. The age of accounts is an indication of credit losses. The aged trial balance provides no evidence about existence.

7.48

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Lapping pertains to cash receipts, not sales. False sales journal entries made near the end of the year may have shipping or other documents that reveal later dates or show lack of sufficient documentation. See answer a. This step would not detect misappropriation of merchandise.

a. b. c.

Incorrect Incorrect Correct

Incorrect

a b

Incorrect Incorrect

Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

c. d.

Incorrect Incorrect

7.46

7.49

7.50

7.51

7.52

Receiving a confirmation is not evidence that the customer will pay. Confirmation will not detect whether the receivables were sold or factored. Accounts receivable confirmation enables recipients to respond that they owe the company or that they dispute or disagree with the amount the company says they owe. Confirmation provides only indirect evidence that controls are working. Prenumbering does not provide any assurance that the document is accurate Prenumbering does not provide any assurance that the document was recorded in the proper period. Checking the sequence for missing numbers identifies documents not yet fully processed in the revenue cycle. It does not provide evidence about accuracy, cutoff, or occurrence. Prenumbering provides no information as to the validity of the transaction. The accounts receivable debits are supposed to represent sales that have been ordered by customers and actually shipped to them. This is not evidence about existence. This provides some evidence about existence, but even if the receivables haven‘t been paid, they may still be valid. These file will likely not provide detailed evidence about specific sales. This is an important assertion, but financial statement users are less likely to be damaged if assets that have not been recorded are found. Financial statement users are more likely to be damaged if assets are found not to exist or assets are overstated. Ownership is important, but doesn‘t matter if the assets don‘t exist. The presentation and disclosure assertion is important but not as important as existence for asset accounts.

7.53

7.54

7.55

7.56

7.57

7.58

7.59

Incorrect

Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

Incorrect

c. d.

Correct Incorrect

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

a. b. c.

Incorrect Incorrect Correct

Auditors would obtain a summary of transactions from the interim date to the year-end date. Auditors would typically perform this analytical procedure if confirmations were performed at an interim date. This is mainly because the other three choices are listed as appropriate work to do. Also, customers are likely to ignore negative confirmations after earlier responding to positive confirmations. If the auditor detects material changes, confirming additional balances would be a likely procedure. Negative confirmations are most appropriate when the assessed level of risk is low, dollar balances on accounts are small, and the auditor believes recipients will give consideration to the confirmations. The auditor assumes customers are likely to respond to errors. Because negative confirmations offer higher detection risk, risk of material misstatement should be low when they are used. Because negative confirmations offer higher detection risk, risk of material misstatement should be low when they are used. Shipments are traced to customers‘ invoices. (This does not imply that the invoices were recorded in the sales journal.) See (a) above. The invoice copies need to be traced to the sales journal and general ledger to determine whether the shipments were recorded as sales. Recorded sales were shipped is not established because the sample selection is from shipments, not from recorded sales. See (c) above. Salespeople could write-off accounts for their friends to keep them from having to pay. The credit manager may propose write-offs to reduce days outstanding and make her or him look better. The treasurer or another high-ranking manager should approve write-offs. The cashier could fraudulently collect cash and write off the balance. A second request is the next action that should be performed. Because the confirmations are a sample of the account balance, even immaterial items should be followed up as they represent other balances in the universe of receivables. Shipping documents should be examined to test the existence of the receivable. Client correspondence files may also provide evidence the receivable exists. Not recording sales on account in the books of original entry is the most effective way to conceal a subsequent theft of cash receipts. The accounts will be incomplete but balanced, and procedures applied to the accounting records will not detect the defalcation. The control account wouldn‘t match the total of customer accounts. Customers would catch the overstatement when examining their statements. This is a possibility, but (a) is a better answer. There is less likelihood of getting caught if the sale is never recorded. The stolen cash wouldn‘t be in either of these documents. Lapping is not accomplished through write-offs. Lapping is the delayed recording of cash receipts to cover a cash shortage. Current receipts are posted to the accounts of customers who paid one or two days previously to avoid complaints (and discovery) when monthly statements are mailed. The best protection is for the customers to send payments directly to

7.60

7.61

7.62

7.63

Incorrect

a. b.

Incorrect Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

the company‘s depository bank. The next best procedure is to ensure that the accounts receivable clerk has no access to cash received by the mail room. Thus, the duties of receiving cash and posting the accounts receivable ledger are segregated. See (a). A negative confirmation might be used if control risk is low. Because detection risk is lower for positive confirmations than negative confirmations, a positive confirmation is more likely when inherent risk is high. Whether the account is due or not usually doesn‘t affect the type of confirmation. However, if it is long past due, a positive confirmation is more appropriate. A related-party account could be a factor that influences a decision to send a positive confirmation. The fact that this account was not a related party would likely lead the auditor to choose a negative confirmation.

Since a large portion of the sales occur in the last month of the year using analytical procedures at an interim date would not be effective. Since a large portion of the sales occur in the last month the auditor needs to test end of year sales, specifically the determination of the timing of sales is important to ensure sales were recorded in the proper period. Since a large portion of the sales occur in the last month of the year using testing internal controls at an interim date would not be effective in determining that year-end sales were accurate. Additional testing through year end would be required. Period-end compensation may or may not be based on sales. Even if period-end compensation is tied to sales, a review of the compensation would not provide evidence of the valuation or cut-off of sales. There is no requirement to confirm accounts receivable that proceed the prior year. Confirmation are generally reserved for accounts that are material to the balance being examined, in this case, accounts receivable. There is no reason for management to intentionally understate accounts receivable. Therefore, this would not be a required account for confirmation. If an account is subject to valuation estimates the auditor needs to review the underlying assumptions of those estimates. Confirming the account will not provide any information regarding the validity of the estimate. Replacement of an accounts receivable with another confirmation is not an acceptable procedure in any situation. The auditor should try to verify that the fax received actually came from an appropriate person at the client. If the auditor cannot verify the legitimacy of the confirmation, the confirmation should be classified as an exception and detailed testing of the underlying transactions should occur. If the auditor can verify the legitimacy of the confirmation, the confirmation may be accepted. Therefore, before classifying the accounts receivable as an exception the auditor should attempt to verify the source. Consequently, answer D is the better answer. Accepting the accounts receivable without verifying that the fax received actually came from the appropriate person at the client is not an acceptable procedure. When a reply to a confirmation is received via fax the auditor must determine that the fax actually came from the appropriate person at the client. A telephone

call to an appropriate person at the respondent‘s company is an acceptable method for verifying the legitimacy of the response.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 7.64

Control Objectives and Procedures Associations

a. ―Occurrence‖ Sales recorded, goods not shipped b. ―Completeness‖ Goods shipped, sales not recorded c. ―Accuracy‖ Goods shipped to a bad credit risk customer d. ―Accuracy‖ Sales billed at the wrong price or wrong quantity e. ―Classification‖ Product line A sales recorded as Product line B f. ―Completeness‖ Failure to post charges to customers for sales g. ―Cutoff‖ January sales recorded in December CONTROL PROCEDURES 1. Sales order approved for credit X 2. Prenumbered shipping doc prepared, sequence checked X 3. Shipping document quantity compared to sales invoice X X 4. Prenumbered sales invoices, sequence checked X 5. Sales invoice checked to sales order X 6. Invoiced prices compared to approved price list X 7. General ledger code checked for sales product lines X 8. Sales dollar batch totals compared to sales journal X X 9. Periodic sales total compared to same period accounts X receivable postings 10. Accountants have instructions to date sales on the date of X shipment 11. Sales entry date compared to shipping doc date X 12. Accounts receivable subsidiary totaled and reconciled to X accounts receivable control account 13. Intercompany accounts reconciled with subsidiary company X records 14. Credit files updated for customer payment history X 15. Overdue customer accounts investigated for collection X X X

X X

7.60

Control Objectives and Procedures Associations (Continued) EXHIBIT 7.57-1 Blank Form for Students

a. b. c. d. e. f. g.

Sales recorded, goods not shipped Goods shipped, sales not recorded Goods shipped to a bad credit risk customer Sales billed at the wrong price or wrong quantity Product line A sales recorded as Product line B Failure to post charges to customers for sales January sales recorded in December CONTROL PROCEDURES 1. Sales order approved for credit 2. Prenumbered shipping doc prepared. sequence checked 3. Shipping document quantity compared to sales invoice 4. Prenumbered sales invoices, sequence checked 5. Sales invoice checked to sales order 6. Invoiced prices compared to approved price list 7. General ledger code checked for sales product lines 8. Sales dollar batch totals compared to sales journal 9. Periodic sales total compared to same period accounts receivable postings 10. Accountants have instructions to date sales on the date of shipment 11. Sales entry date compared to shipping doc date 12. Accounts receivable subsidiary totaled and reconciled to accounts receivable control account 13. Intercompany accounts reconciled with subsidiary company records 14. Credit files updated for customer payment history 15. Overdue customer accounts investigated for collection

7.65

Control Assertion Associations Error

Assertions a.

Sales recorded, goods not shipped

Occurrence

Goods shipped, sales not recorded

Completeness

Goods shipped to a bad credit risk customer

Accuracy (or Valuation of A/R)

Sales billed at the wrong price or wrong quantity

Accuracy

Product A sales recorded as Product line B

Classification

7.66

Failure to post charges to customers for sales

Completeness

January sales recorded in December

Cutoff

Client Control Procedures and Audit Tests of Controls

Sales invoice sample: Select a sample of random numbers representing recorded sales invoices, and 1(a).

Inspect the attached sales order for credit approval signature.

1(b).

Trace customer to up-to-date credit file/information underlying the credit approval.

Inspect the attached shipping document for (a) existence, and (b) prenumbering imprint.

Compare billed quantity on sales invoice to shipped quantity on shipping document.

Find the sales invoice associated with the random number (failure to find this means an invoice wasn‘t recorded). Alternatively, use the computer to add up the recorded sales invoice numbers and compare to a sum of digits check total.

Compare sales invoice to sales order for quantity, price, and other terms.

Compare prices on sales invoice to approved price list.

Check product line code for proper classification compared to products invoices.

11. 14.

Compare invoice date to shipping document date. Note whether credit files are updated for customer payment history.

Other 2.

Count the number of shipping documents (subtract beginning number from ending number) and compare to same-period count of sales invoices (to look for different number of documents).

Select a sample of random numbers representing shipping documents and look for them in the shipping document file.

Computer-scan the shipping document file for missing numbers in sequence.

Use computer to add the shipping document numbers entered in the files and compare to a computed sum of digits check total.

Find client‘s sales dollar batch totals, recalculate the total, and compare to sales journal of the relevant period.

Use the same sales dollar batch totals for comparison to separate total of accounts receivable subsidiary postings, if available.

7.67

10.

Study the accounting manual on date of shipment and make inquiry about accountants‘ instructions to date sales.

12.

Obtain client‘s documentation showing the accounts receivable subsidiary total reconciled to the accounts receivable control account. Alternatively, total the subsidiary and compare the amount to the control account.

13.

Obtain client‘s documentation showing reconciliation of intercompany receivables and payables for sales and purchases. Alternatively, confirm balances with subsidiaries or other auditors.

14.

Select a sample of credit files and trace to customers‘ accounts receivable, noting extent of update for payment history.

15.

Study client correspondence on investigation and collection efforts on overdue customer accounts, noting any dispute conditions. If no effort is made, follow up overdue accounts with audit procedures (confirmation, determine existence of debtor in directories, etc.)

Confirmation of Trade Accounts Receivable a.

Auditing standards presume that auditors will request confirmation of the client‘s accounts receivable. An auditor can justify omitting these confirmations if: (1)

The accounts receivable are immaterial to the financial statements.

(2)

The expected response rates to properly designed confirmation requests will be inadequate, or responses are expected to be unreliable; hence, the confirmation procedures would be ineffective.

(3)

The evidence expected to be provided by analytical procedures or other substantive procedures is sufficient to reduce audit risk to an acceptably low level for the applicable financial statement assertions.

These factors will affect the reliability of confirmations: (1) The confirmation form. Some positive forms request agreement or disagreement with information stated on the form. Other positive forms, known as blank forms, request the respondent to fill in the balance or furnish other information. Negative forms request a response only if the recipient disagrees with the information stated on the request. (2) The auditor‘s prior experience with this client or similar clients is also likely to affect reliability because the auditor will have prior knowledge of the expected confirmation response rates, inaccurate information on prior years‘ confirmations, and misstatements identified during prior audits. (3)The nature of the information being confirmed may affect the competence of the evidence obtained as well as the response rate. For example, this client‘s customers‘ accounting systems may permit confirmation of individual transactions, but not account balances, or vice versa. (4)Sending the confirmation requests to the proper respondents will likely provide meaningful and competent evidence. Each request should be sent to a person the auditor believes is knowledgeable about the information to be confirmed.

The nature of the alternative procedures the auditor can apply when replies to positive confirmation requests are not received varies according to the account and assertion in question. Possible alternative procedures include: (1) Examining subsequent cash receipts and matching such receipts with the actual items being paid. (2) Considering inspecting the client‘s customers‘ purchase orders on file and related shipping documents. (3) Inspecting correspondence between the client and its customers could provide additional evidence. (4) Establishing the existence of the client‘s customers by reference to credit sources such as Dun & Bradstreet or other sources of identification (e.g., telephone book, business directories, state incorporation files).

7.68

Audit Objectives and Procedures for Accounts Receivable a.

Accounts receivable represent all amounts owed to the client company at the balance sheet date. 2.

Perform sales cutoff tests to obtain assurance that sales transactions and corresponding entries for inventories and cost of goods sold are recorded in the same and proper period.

The client company has a legal right to all accounts receivable at the balance sheet date. 5. (best)

Review loan agreements for indications of whether accounts receivable have been factored or pledged.

4. (possible)

Obtain an understanding of the business purpose of transactions that resulted in accounts receivable balances.

Accounts receivable are stated at net realizable value. 3.

7.69

Review the aged trial balance for significant past due accounts to determine if they are realizable.

Accounts receivable are properly described and presented in the financial statements. 6. (best)

Review the accounts receivable trial balance for amounts due from officers and employees.

4. (possible)

Obtain an understanding of the business purpose of transactions that resulted in accounts receivable balances.

Overstated Sales and Accounts Receivable AUDIT APPROACH Objective Obtain evidence to determine whether sales were recorded in the proper period and whether gross accounts receivable represented the amounts due from customers at year-end. Control

Sales terms should be properly documented. Accounting treatment, including billing at agreed-upon prices, should follow the terms of the sale. If the risks and rewards of ownership have not been transferred to the customer, or the price has not been reliably determined, or the collectibility of the amount is seriously in doubt or not estimable, an accrual sale should not be recognized. Recorded sales should be supported by customer orders and agreements. Shipping documents should be sufficient to show actual shipment or a legitimate field warehousing arrangement. Tests of Controls Questionnaires and inquiries should be used to determine the company‘s accounting policies. If the auditors do not know about ―bill-and-hold‖ practices, they should learn the details. For detail procedures, select a sample of recorded sales, and examine them for any signs of unusual sales terms. Vouch them to customer orders and other sales agreements, if any. Vouch them to shipping documents, and examine the documents for external reliability—recognizing blank spaces (carrier name, date) and company representative‘s signature (two places, both company and carrier). Compare prices asked in customers‘ orders to prices charged on invoices. These tests follow the vouching direction—starting with data that represent the final recorded transactions (sales) and going back to find originating supporting source documents. These procedures might reveal some transactions of the problem types—bill and hold, and overbilling. The last month of the fiscal year (although a typical seasonal low month) could be targeted for more attention because the sales are much higher than the previous January and because the auditors want to pay attention to sales cutoff in the last month. Select a sample of shipping documents, trace them to customer orders, and trace them to invoices and to recording in the accounts receivable with proper amounts on the proper date. These tests follow the tracing direction: starting with data that represent the beginning of transactions (orders, shipping) and tracing them through the company‘s accounting process. If extra attention is given in January for cutoff reasons, this sample might reveal some of the problem transactions. Audit of Balance Confirm a sample of customer accounts. Follow up exceptions noted by customers relating to bill and hold terms, excessive prices, and double billing. Even a few exceptions raise red flags for the population of receivables. Use analytical comparison on comparative month‘s sales. Investigate any unusual fluctuations (e.g., January this year much higher than January last year, the reversal month next year with negative sales). The January comparative increase in sales should cause auditors to extend detail procedures on some of the month‘s transactions. Discovery Summary The auditors performed a detail sales cutoff test on January sales, selecting a sample of recorded sales. However, they did not notice the significance of ―bill and hold‖ marked on the invoices, and they did not figure out the meaning of the blank spaces and duplicate company employee signatures on the shipping documents. In the following year‘s audit, they tested sales transactions in a month when the prior-year bill–and-hold sales were reversed. They noticed the discrepancy but were told that it involved various billing errors. They did not connect it with reversal of the prior-year sales.

The auditors confirmed a judgment sample of large accounts receivable balances. Twelve replies were received on 103 confirmations. Six of the replies were from bill-and-hold customers who listed discrepancies. The auditors followed up the six by examining sales invoices and shipping documents. They did not grasp the significance of the bill-and-hold stamps or the features of the shipping documents described earlier. Three confirmation responses indicated the customers did not owe the amounts. The auditors relied on Mattel internal documents to decide that the customers were wrong. They did not examine the sales orders that indicated that these customers had a right of cancellation. The auditors did not perform month-by-month analytical sales comparisons with the prior year. Thus, they did not recognize the significant fluctuations in the comparative January sales. In the next year‘s audit, they did not recognize the significant comparative decrease in monthly sales for the months when the prior-year bill-and-hold sales were reversed. 7.70

CAATs Application—Receivables Confirmation File

7.71

Information

Master File—Debtor Name

Name of Debtor Address of Debtor

Master File—Account Detail

Customer Account Number Balance (gross) Discount Available to Customer

Audit Simulation: Rock Island Quarry—Evidence Collection in an Online System This case is a summary of an actual situation and should be used to generate discussion of how auditors must adapt to a changing environment. The solution suggested here represents the preliminary response by the audit firm involved. You and your students will likely generate additional responses. a.

(1)

Program change controls—The primary concern is the security of the programs that process the quarry transactions at the quarry‘s computers and at the home office. Assuming that the auditors can test and evaluate these programs, the concern is how changes are made in a controlled, authorized fashion. The auditors need assurance that the same programs are used by all locations throughout the period.

(2)

Access controls—Who is authorized to operate the quarry computers and how are unauthorized personnel prevented from operations? Although not mentioned in the case, access should be controlled through the use of a weigh master‘s identification number and password (changed periodically). Physical access should also be evaluated. Are the computers kept in a locked, secure area?

(3)

Sales transaction program controls—The system described is not unlike any online sales order entry system. Certain edit or validation controls should be incorporated such as (a) limit tests (for impossible weights and out-of-range numbers for rock grade), (b) missing data tests (all fields have data), (c) valid character and sign tests (appropriate fields numeric and positive), and (d) sequence tests (transaction numbers in sequence, by quarry).

(4)

Completeness controls—The system has to contain controls that ensure that all transactions sent by the quarries are received at the home office. These can be as simple as a signal sent back to the quarry microcomputer that the sale was received and as complex as having the microcomputer accumulate control totals that are matched to home office control totals at the end of the day. In such distributed systems, the computers would most likely store all transactions (keep an onsite log) until receipt is confirmed. A transaction-numbering scheme can also ensure that no transactions were missed.

The implication of the programs residing in the computers at the quarries is that programs may be changed there as well as from the home office. Therefore, the change controls mentioned above are important as well as how program modifications are made to the quarry computers. Obviously, several sites will have to be visited.

Auditors debate whether ―documentary evidence‖ includes evidence in computer-readable form. The authors believe such evidence should be considered documentary evidence. The problem then becomes one of whether this computer-readable evidence will be available during the period under audit. In all probability, a log of all incoming transactions is captured at the home office so that a complete audit trail exists. The auditors need to request that these logs be retained. If the logs are available, generalized audit software can be used to select samples to be printed. If the logs are not retained, sampling will have to be done during transaction occurrence rather than after the fact. This would involve selected testing throughout the audit period. The system described would also be appropriate for CAATs. A final point to have the class discuss is what is likely to happen when one of the computers goes down at one of the quarries or the entire network is down. Rock Island will have to provide manual backup procedures, which are normally not well controlled and thus become subject to errors and frauds.

7.72

Organizing a Risk Analysis TO: FROM: DATE: SUBJECT:

Senior Internal Auditor Director of Internal Auditing November 31, 20XX Risk analysis of accounts receivable accounting

These questions are for your guidance. The Problem Total patient accounts receivable have increased steadily and rapidly for eight months. Our last audit of this area was 10 months ago. A favorable report is in the working paper file. I can see no apparent reason for the increase because the number of beds, the occupancy rate, the billing rates and the insurance contracts have not changed. What Financial/Economic Events Have Occurred in the Last 10 Months? 1. 2. 3. 4. 5.

Are a higher number of patients uninsured? Is a larger number or greater dollar amount overdue? Have any accounts been written off in the last 10 months? Number? Dollar amount? Which accounts are presently considered doubtful of collection? Why? Have patients complained about their bills?

Who Does the Accounting? 1. 2. 3.

Are new people doing the accounting? Who is the accounting manager now? Did employees give reasons for resigning?

What Data Processing Procedures and Policies Are in Effect? 1a. 1b. 2a. 2b. 3a. 3b. 3c.

What are the current procedures for billing patients? What changes have been made in the last 10 months? What are the current procedures for recording changes and collections? What changes have been effected in the last 10 months? What are the credit and collection policies? Are they being followed? What changes have been effected in the last 10 months?

How Is the Accounts Receivable Accounting Done? 1. 2.

7.73

Has the accounting been put on computer within the last 10 months? How many employees handle the accounting? Computer ______________________ Noncomputer ___________________

Study and Evaluation of Management Control TO: FROM: DATE: SUBJECT:

Internal Audit Staff Senior Internal Auditor July Comparison standards for study and evaluation of management risk mitigation control policies

To audit the performance of management controls, you will need to know quantitative standards of acceptable performance. Standards for two policies are described in this memo. 1. Sales are billed to customers accurately and promptly. a.

Accuracy Policy standard: No more than 3 percent of the sales invoices are figured with errors of either quantity or unit price or extension error amounting to over $1 per invoice. Audit procedures: (1)

Audit for accuracy by selecting a sample of recorded sales invoices and (a) vouch the customer name to supporting purchase orders and shipping documents, (b) vouch the quantity shipped to supporting shipping documents, (c) trace the unit price to the approved price list, and (d) recalculate the extensions, including shipping charges and sales tax. Document all errors over $1 per invoice.

(2)

Audit for completeness by selecting a sample of shipping documents and tracing them to recorded sales invoices.

(3)

Audit for accuracy (related to shipping quantities, primarily) by confirming a sample of customers‘ balances (or individual unpaid invoices) and look for customer disagreements.

Promptness Policy standard: Sales invoices are to be entered in the sales journal and in customers‘ accounts with a (mailing) date no later than one day after shipment. Audit procedure: Using the samples in procedures 1 and 2 above, compare the sales journal record date and the date shown in customers‘ accounts with the shipment date. Document the number and extent of time lags exceeding one day. Inquire about the mailing date.

Accounts receivable are aged and followed up to ensure prompt collection. (a)

Receivable aging Policy standard: A complete and accurate aged trial balance is prepared monthly showing receivables in categories (1) current, (2) 31-59 days overdue, (3) 60-89 days overdue, and (4) more than 90 days overdue. Audit procedures:

(1)

Inspect the aged trial balances to determine whether they were actually prepared each month.

(2)

Audit for completeness by comparing the trial balance total to the general ledger control account. (foot each if necessary.)

(3)

Audit for accuracy by selecting a sample of customer accounts and tracing aged data from the customers‘ ledger accounts to the aged trial balance. This is the important direction for the procedures because incorrect ―underaging‖ thwarts the collection effort. (Selecting a sample of noncurrent aging data from the trial balance will not enable you to detect noncurrent amounts incorrectly aged as current.)

Follow-up for prompt collection Policy standard: Credit department personnel are supposed to receive the trial balance within five days after each month-end and send different letters within five business days of receiving the aged trial balance for accounts as they become longer overdue and to turn accounts over to an outside collection agency when they are more than 90 days past due. After 60 days, further credit is cut off and customers are put on a cash basis. Audit procedure: (1)

Inspect the aged trial balances for indication of preparation date or a ―date received‖ stamp by the credit department to determine promptness of transmittal within five days after each month-end.

7.74

(2)

For a sample of past due amounts in different months, inspect copies of the letters sent to customers and (a) observe whether the correct standard letter was sent and (b) the date. Document exceptions to type of letter and mailing delay.

(3)

Inspect correspondence relevant to determining the date that more than 90-day accounts were turned over to an outside agent.

(4)

Inspect notices of credit cutoff for customers with more than 60-day balances and inspect the trial balance for evidence of new credit mistakenly extended to such customers.

(5)

Using the sample obtained in (2), verify the accuracy of the subsequent collections report prepared by the credit department by vouching the data therein to cash receipts records.

Receipts and Billing Control Dealing with these weaknesses gives students an opportunity to think about fraud possibilities that could occur with and without collusion among these four employees. A useful discussion of intentional frauds can be built around the weaknesses and possibilities shown in the following in the AICPA CPA Examination answer to this problem. Credit Manager  Approves credit without reference to rating agencies (e.g., Dun & Bradstreet).  Approves credit without using any established credit limits or policy.  No supervision of the credit-granting function and no reviews of the results of the credit manager‘s credit decisions. Accounts Receivable Supervisor 

Can alter the details of customer charges (authorize-initiate transactions) and prepare invoices and records based on the alterations (a form of recordkeeping in this system).



Does not use a control total (e.g., daily batch financial total) of the charge forms in comparison to the total on the invoices and nobody else knows whether the totals agree.



Does not reconcile the accounts receivable subsidiary ledger with the control account balance (therefore can write-off accounts for friends because nobody reconciles the totals and nobody compares the actual write-offs to the bookkeeper‘s authorizations) (also the A/R supervisor can simply not put a contractor‘s balance on the report of overdue balances and therefore permit the contractor to obtain additional credit past the standard six-month period).

Cashier 

Has custody of cash and controls the record keeping (the latter by sending the bookkeeper the only documents—the remittance advices and daily cash register summary— available for recording the cash receipts).



Can alter or delay the bookkeeper‘s cash information because no one else has the verified deposit slip or the list of checks for comparison.



Performs the bank reconciliation, which is not compatible with the cash custody and recordkeeping duties (can alter the reconciliation to cover up cash shortages).

Bookkeeper

7.75



Authorizes account write-offs according to a fixed policy (six-month nonpayment period) without reference to knowledge of reasons or details (and apparently without further correspondence with the contractor).



Allows a six-month grace period that is too long, and may grant credit for a time when it is not justified.



Can control the credit-refusal process by not notifying the credit manager of the overdue accounts.



Can authorize and actually write off accounts without supervision (has the incompatible duties of authorization-initiation of write-off orders and actually making entries in the records).

Test of Controls and Errors/Frauds 1.

Controlled access to blank sales invoices a.

Observation. Visit the storage location yourself and see whether unauthorized persons could obtain blank sales invoices. Pick some up yourself to see what happens.

Someone could pick up a blank sales invoice and make a fictitious sale. However, getting it recorded would be difficult because of the other controls such as matching with a copy from the shipping department. (Thus, a control access deficiency may be compensated for by other control procedures.) Sales invoices prenumbered and accounted for. a. b.

Inspection of sales invoices and observation. Scan sales invoices for numerical sequence and observe client checking for sequence. Valid sales may not be recorded (completeness of sales/A/R) or may not be recorded on a timely basis (cut-off of sales).

Sales invoices check for accuracy a.

Vouching and recalculation. Select a sample of recorded sales invoices and vouch quantities thereon to bills of lading, vouch prices to price lists, and recalculate the math.

Errors on the invoice could cause lost billings and lost revenue or overcharges to customers that are not collectible (thus, overstating sales and accounts receivable - the accuracy/valuation assertion).

Duties of accounts receivable bookkeeper a.

Observation and inquiry. Look to see who is performing bookkeeping and cash functions. Determine who is assigned to each function by reading organization charts. Ask other employees.

The bookkeeper might be able to embezzle cash and manipulate the accounting records to give the customer credit and hide the theft. (Debit a customer‘s payment to Returns and Allowances instead of to cash or just charge the control total improperly.

Customer accounts regularly balanced with the control account

7.76

Inquiry and Reperformance. Inquire with client staff about process. Review the client‘s documentation showing the balancing/reconciliation. Reperform the balancing yourself.

Accounting entries could be made inaccurately or incompletely and the control account may be overstated or understated.

Customers receive a monthly statement even when the ending balance is zero. a.

Inquiry and inspection of documents. Talk with employees about process for sending monthly statements and inspect evidence of monthly statements being sent to all customers, including zero balance customers (likely electronic).

Fictitious sales could be recorded and not detected (occurrence of sales). Customer complaints regarding billing may help detect fictitious sales. Errors, including nonrecorded sales (completeness or sales and A/R) or sales recorded to the incorrect customer (classification of A/R) may also be detected. Further, failure to send monthly statements can increase the difficulty of collections (valuation of A/R).

Revenue Recognition and Ethics

Instructor’s note: The answers to this case are numerous, and the case is meant to initiate a discussion as to the subtleties of auditing revenue and the nature of the auditor‘s responsibilities. a.

Several fraud issues have arisen because the auditor looked only at the numbers but did not look at how the numbers were generated. In many of these instances, sales were fictitious or inflated. While this case does not involve such blatant financial statement fraud, ―bait and switch‖ is considered fraud. In attempting to manage the audit risk, it is clear that auditors must look at business practices and determine that the client is generating review legally. However, audit standards are clear that determining whether an act is illegal is beyond an auditor‘s competence (SAS 54). If it is likely that the revenue is uncertain in its amount, there should be an adjustment to reduce revenue by the amount deemed uncertain. The footnote for revenue should disclose the reason for the adjustment. If the financial statements were issued during the investigations and a loss appeared to be reasonably possible, the auditor should ask for a footnote disclosure (FASB 5).

Follow-up note: Subsequent to the preceding article and the imitation of the investigations, Ticketmaster refunded a substantial part of the revenue to customers who had purchased tickets on TicketsNow. 7.77

Substantive Analytical Procedures a.

Estimated Ticket Revenues: (50,000 x 2 games) x $56/ticket = $5,600,000 (75,000 x 4 games) x $56/ticket = $16,800,000 (88,300 x 1 game) x $56/ticket = $4,944,800 Total estimated ticket revenue $27,344,800

The facts of the question state that unaudited ticket revenues are $26,600,000. The difference between the estimated revenues and the reported revenues is a $744,800 shortfall. This is greater than the tolerable misstatement of $500,000, so we are unable to conclude that the reported revenues appear to be fairly stated. However, we do not have sufficient evidence to conclude that they are NOT fairly stated either. The auditor will need to perform additional substantive procedures. Some procedures which would likely be performed: 1-179 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7.78.1

Obtain a schedule of actual ticket sales on a per game basis to obtain a better estimate. Ideally, the listing of tickets issued could be obtained from someone with no access to recording or authorizing ticket sales. With proper segregation of duties, the custody of tickets should be separate from authorization and recordkeeping functions. - Obtain a listing of invoices for ticket sales and select a sample of ticket sales. Trace ticket sales to recorded revenues to test the completeness assertion. Yes, substantive analytical procedures are allowed under Generally Accepted Auditing Standards and may in some cases be sufficient appropriate evidence for some assertions. Analytical procedures are required in the audit for both risk assessment and reaching overall conclusions, but they are not required for substantive procedures. Authorization of Credit Tests of Controls – Using IDEAT

Instructor’s note: The IDEA Workbook version 10 walks students directly through this exercise and provides the answers (and steps to reach the answers) for parts (a) and (b) below. However, it does not provide an interpretation of the audit effects. Thus, part (c) is not answered in the IDEA Workbook. a.

b. c.

7.79

After following the instructions in the IDEA workbook, the field statistics will show 16 accounts with a total value of $161,345.68 where the credit limit was exceeded. A further evaluation of this will indicate that 14 of these accounts had no matches in the Customer Master database. Two customers exceeded their credit limit. The findings in parts (a) and (b) are indicative of a failure in the operating effectiveness of credit controls. This failure would prevent the auditor from assessing control risk surrounding the valuation assertion of accounts receivable (accuracy assertion of sales revenue) at the planned level. Thus, control risk would increase, indicating an increase in the risk of material misstatements. As indicated, the primary accounts and assertions influenced by these findings are the valuation of accounts receivable and the accuracy of sales revenue. However, the finding that 14 customers were granted credit without even being listed may be considered a red flag related to increased risk of fraud in the revenue cycle, which would also influence risk of material misstatement related to the occurrence of sales revenue and existence of accounts receivable.

Test of Control Exceptions with IDEA

Instructor’s note : Videos outlining loading the data into IDEA and detailed video solutions to this exercise are available on the Connect site. a. b.

c. d. e.

Using the Analysis->Gap Detection function with standard options demonstrates that there are three missing ORDERNO: 17024, 17082, and 17090. Using the Analysis->Duplicate Key function and verifying that ORDERNO is the key, you will find there are 16 total records sharing an ORDERNO with other orders. The total ORDERPRICE of these items is $50,856. The totals can be found by clicking “Field Statistics” within the Database properties on the right side of the IDEA window. The auditor will need to determine if these duplicate orders represent control exceptions or possibly fictitious or duplicate sales recordings. Using Analysis->Direct and the equation CREDAPR <>”Y” .AND. CREDAPR <> “y”, you find there are 20 orders that show no evidence of authorization. Eight of these orders have not been shipped and may not represent control exceptions. The company clearly has a substantial problem with invoicing customers in accordance with the 2-day policy. Using the Analysis->Direct and the equation @AGE(INVDATE, SHIPDATE) > 2, we find that there were 199 orders that were not invoiced within two days of the shipment date. See memo

To: ELM Manufacturing Audit File From: Staff Auditor Date: September 29, 2021 RE: Revenue Cycle Control testing 1-180 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

During our tests of revenue cycle controls, we would the following control deficiencies: -

ELM did not maintain complete sequencing of customer orders. We found three missing customer order numbers and 16 that were used in duplicate. This finding indicates that this control surrounding the completeness assertion cannot be relied upon. ELM shipped 12 orders during the 4th quarter without evidence of credit approval marked in the order file. This violates the company policy and reduces our ability to rely on approval controls related to the valuation of accounts receivable. ELM does not invoice customers on a timely basis. Nearly half of all invoices were sent to customers more than two days after order shipment. This results in control deficiencies related to completeness and cutoff of sales revenues, as well as potential issues with completeness and valuation of receivables.

These findings indicate that the level of control risk must be increased above the planned reliance for the occurrence, completeness and cutoff assertions of sales revenue, and the existence, completeness, and valuation assertions of accounts receivable. 7.80

Tests of Controls with IDEA – Payment Receipts

Instructor’s note : detailed video solutions to this exercise are available on the Connect site. a.

c. d.

Using the Analysis->Direct, we extract companies where the PAYDATE is more than 32 days after the INVDATE, @age(PAYDATE, INVDATE)>32. There were six companies with eight payments that were received after the due date (this does not count companies that did not pay at all), including the two day grace period. The total amounts of the late payments were $9,665.18. To determine the number of companies, you can use Analysis->Pivot Table and drag CUSTNO into the row field, with PAYMENT in the data fields. This will show both number of customers and total amount. There were 16 payments made where a discount was taken despite the company not being eligible to take a discount. In addition, there are 11 more outstanding invoices with a discount amount listed despite the company not being eligible. The total of amount of discounts taken were $828.48. This solution requires multiple steps. See video for details. There are five customers taking discounts that are greater than the amount in the policy, although several of these have not paid yet. Only two of these represent actual discounts taken. 0 There were 27 discounts taken after the deadline for eligibility. The total amount of discounts taken incorrectly was $23,352.96.

7.81 Testing the Valuation Assertion with IDEA – Aging Accounts Receivable Instructor’s note : A video outlining the solution to this exercise is available on the Connect site. a.

To complete an aging schedule, first you must extract the actual accounts receivable. To do this, first extract (Analysis->Direct) orders that are shipped and invoiced, but have not been paid yet (PAYMENT=0 .AND. (INVDATE>=”20200101” .AND. INVDATE<”20200401”). This extraction should retrieve 137 items in A/R. To create an aging schedule, use Analysis->Aging and assign payment tranches of 32 days (these are current receivables – recall that payments are granted a two-day grace period), 62 days (these will be less than 30 days delinquent). You may either put in another value or leave the remainder blank. See video for specific details.

b. c.

The total amount of A/R is $707,378.15. There were four delinquent receivables that were less than 30 days past due with a total invoice amount of $41,865.90. There were two delinquent receivables that were greater than 30 days past due with a total invoice amount of $2,101.15.

CHAPTER 08

Acquisition and Expenditure Cycle LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1. Describe the acquisition and expenditure cycle, including typical source documents.

1, 2, 3

29, 30, 31, 32

50(*), 55(*)

2. Identify significant accounts and

4, 5, 6

50(*), 58(*), 59(*), 62(*)

relevant assertions related to the acquisition and expenditure cycle. 34, 35

Discuss the risk of material misstatement in the acquisition and expenditure cycle.

7, 8

4. Identify important internal control

9, 10

36, 37, 42, 43, 48

54(*), 55(*), 62(*)

11, 12

50(*), 54(*)

13, 14, 14, 16, 17, 18, 19, 20, 21

38, 39, 44, 45, 46, 49

51, 52(*), 53, 54(*), 57(*), 58(*), 59(*), 60, 62(*)

52(*)

activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion in the acquisition and expenditure cycle.

5. Give examples of tests of controls

to test the operating effectiveness of internal controls in the acquisition and expenditure cycle.

Give examples of substantive procedures in the acquisition and expenditure cycle and relate them to assertions about significant account balances at the end of the period.

Apply your knowledge to perform audit procedures in the acquisition and expenditure cycle and evaluate the findings of your tests.

8. Describe the payroll cycle including risks, source documents and controls (Appendix 8C)

22, 23, 24, 25, 26, 27

8C1, 8C2 8C3, 8C4, 8C5, 8C6, 8C7,

53, 54(*), 58, 59 (*), 63, 64, 65, 66

8C8, 8C9, 8C10, 8C11, 8C12, 8C13, 8C14, 8C15, 8C16, 8C17

8C18, 8C19, 8C20, 8C21, 8C22

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 8.1

A voucher is a package of documents, usually with a cover page. (The package can be a small envelope.) The voucher package contains supporting documents for a transaction. For example, a purchase voucher usually contains a purchase requisition, purchase order, receiving report, vendor invoice, and a negotiable check (check copy when the vendor invoice has been paid). Required approvals and signatures are on the documents. The voucher presents evidence of the documentation and control over a transaction. Computerized systems may have all this documentation in memory. In a voucher system, each voucher is ―payable‖ and the detail of the payables is the vouchers themselves. At any time, the company may owe a single vendor more than one invoice represented on several vouchers. In a voucher system, there is no balance payable to each vendor—just a file of different vouchers payable.

8.2

A purchasing manager can direct purchases toward vendors who provide the manager kickbacks or other inducements. This can be prevented by notifying suppliers that the company will not permit payment of kickbacks to its employees. The company can also rotate purchasing managers to different vendors. Finally, significant purchases should be reviewed and approved by a higher level manager.

8.3

A ―blind‖ purchase order is a purchase order that does not display the quantity ordered. It is given to the receiving department so personnel there will know what has been ordered, but they will have to do an independent count. If a blind purchase order is not used, receiving personnel may not count the goods received and just record the amount indicated on the purchase order.

8.4

Management could omit expenses and liabilities if they desired to manipulate the financial statements. Therefore management might not record, or delay the recording, of expenses and liabilities.

8.5

Management may not record or delay recording the inventory sale in order to keep inventory accounts high and cost of goods sold low.

8.6

If a fictitious expense is included in the records (e.g. an expense to pay a fictitious vendor) there must be a credit to an accounts payable and a debit to a corresponding account. If the debit is for a tangible assets (e.g. inventory, supplies, PPE) someone will want to see the assets or have a record of the receipt of the assets. If the corresponding debit is for a service, no asset exists for inspection and it may be more difficult

to verify via documentation. Also, expense accounts get closed at the end of the year. A fraud near the end of the year involving service expenses has a smaller window of discovery. 8.7

In the short term, capitalizing ordinary expenditures increases assets and decreases expenditures. Therefore, this type of manipulation makes the balance sheet and income statements appear better. However, capitalized expenses need to be amortized in future periods, so these improperly capitalized expenditures show up in future periods as additional expenses and reduced assets.

8.8

If a credit to accounts payable is omitted, a corresponding debit is also omitted. The debit may include inventory, PPE, prepaid expenses (e.g. prepaid rent), services (e.g. computer repair) and a variety of expenses.

8.9

The functions that should be separated to maintain internal control in a purchasing system include (a) custody of the goods (receiving and stores departments), (b) authority to initiate a transaction (purchasing department), (c) bookkeeping (accounts payable department, inventory record-keeping department), and (d) periodic physical counts (reconciliation) of inventory and fixed assets.

8.10

In the acquisition and expenditure cycle those individuals authorizing procurement of goods and services (i.e. purchasing) should be separate from record keeping (i.e. accounts payable) and from the various departments that receive, store, and use the material received (e.g. inventory, production, warehousing, engineering, receiving).

8.11

The best testing for proper authorization is to select a sample of received materials (select the sample form the accounts payable journal or receiving report file) and vouch the order to purchase order. The purchase order should be inspected for evidence of authorization by the appropriate purchasing agent(s)

8.12

Payment of a vendor is authorized using a voucher package. Once a ―three-way‖ match is performed (matching and reconciling the purchase order, receiving report and vendor invoice) the voucher package is signed off. This sign off is the authorization to pay the vendor.

8.13

You will find evidence about losses on purchase commitments in the open purchase order file. Evidence about unrecorded liabilities to vendors is in the (a) unmatched invoice file and (b) unmatched receiving report file.

8.14

Management reports that can be used for audit evidence, and information in them can be useful to auditors are as follows: 

Open purchase orders: Purchase commitments, losses on purchase commitments.



Unmatched receiving reports: Goods received but not recorded as purchases or liabilities.



Unmatched vendor invoices: Unrecorded invoices that may represent unrecorded liabilities or items in dispute



Accounts payable trial balance: Subsidiary ledger of accounts payable that may show balances by vendors, indicating small balances that should be large. Invoice dates may reveal failure to record invoices late in the accounting period.



Purchases journal: Listing of all purchases available for analysis of purchasing patterns and oddities. Population for sample of purchases for tests of controls.



Fixed asset reports: Fixed assets subsidiary ledger trial balance. Scan for negative balances, capitalized repairs, and depreciation in excess of salvage value; depreciation recalculation.

8.15

(a) A low risk of material misstatement would normally result in a strategy by which the auditor relies on controls and reduces substantive tests. First, the auditor would confirm the low control risk evaluation by testing controls for effectiveness. More reliance would also be placed on analytical procedures. (b) High risk of material misstatement would result in a more substantive approach with little control testing.

8.16

The purpose of the auditor‘s search for unrecorded liabilities is to gather evidence as to whether the completeness assertion is true. From an evidence-gathering perspective, it is much more difficult to gather evidence on unrecorded transactions than to gather evidence that recorded account balances exist. 

Inquire of client personnel about their procedures for ensuring that all liabilities are recorded.



Scan the open purchase order file at year-end for indications of material purchase commitments at fixed prices. Obtain current prices and determine whether any adjustments for loss and liability for purchase commitments are needed.



Examine the unmatched vendor invoices listing and determine when the goods were received, looking to the unmatched receiving report file and receiving reports prepared after the year-end. Determine which invoices, if any, should be recorded.



Trace the unmatched receiving reports to accounts payable entries, and determine whether entries recorded in the next accounting period need to be adjusted to report them in the current accounting period under audit.



Select a sample of cash disbursements from the accounting period following the balance sheet date. Vouch them to supporting documents (invoice, receiving report) to determine whether the related liabilities were recorded in the proper accounting period.



Confirm accounts payable with vendors (especially regular suppliers showing small or zero balances in the year-end accounts payable.

8.17

Financial statement users are most troubled by overstated assets and understated liabilities. Therefore, they need to audit more for the existence of assets and the completeness of liabilities.

8.18

Typically, when auditing prepaids and accruals, the auditor uses audit documentation that shows beginning balances, payments, expense, and ending balance. By agreeing beginning balance to prior-years audit documentation, vouching payments, and calculating the accuracy of the ending balance, the auditor knows that the amount charged to expense will be correct.

8.19

Noncurrent assets such as property, plant, and equipment and intangibles usually pertain to all four management assertions about account balances: existence, completeness, rights and obligations, and valuation and allocation. The auditor must ensure that they exist and are owned. In addition, the valuation determined by depreciation, amortization, or impairment charges is usually an important issue. Of the four assertions, completeness is probably the least important, but it cannot be ignored.

8.20

The auditor is primarily concerned with current-year transactions in property, plant, and equipment accounts. Previous years require less attention because they were audited in prior years. Thus, additions, disposals, and depreciation charges warrant the most attention.

8.21

Most expense accounts can be tested through analytical review procedures, substantive tests of transactions, or by testing them in conjunction with tests of related assets and liabilities (e.g., depreciation). Some expenses should be examined separately because of their unique nature (e.g., legal expenses or miscellaneous expense).

8.22

The following are possible red flags indicating a risk of fraud: 1-185 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

         

Photocopies of invoices in the files. Vendor‘s invoices submitted in numerical order. Vendor‘s invoice amounts always in round numbers. Vendor‘s invoices are consistently slightly lower than the review threshold set by management. Vendors with only post office box addresses. Vendors with no listed telephone number. Matching vendor and employee addresses or telephone numbers. Multiple vendors at the same address and telephone number. Vendors not on the approved vendor list. Knowing the address of the local mail drops (e.g., shipping and packaging stores that accept client mail). These stores could provide a street address for fraudulent companies, adding false legitimacy to their fraudulent invoices.

8.23

The auditor should begin by inquiring of the client about its knowledge of fraud or fraud risks. Analytical review procedures such as vertical and horizontal analyses can pinpoint accounts that appear to have unusual fluctuations. Examining invoices and vendor files for the red flags noted in 8.12 will help find phony billings. The purpose is to identify fraud risk, evaluate the significance of the risk, and determine the amounts of any actual fraud on the financial statements.

8.24

Most of the procedures are designed to prevent misappropriation of assets. The expenditure cycle is an area where employees may attempt to receive payments for fictitious purchases or have the company pay for personal items run through the expenditure system as a company expense. Procedures targeted at financial statement fraud include searching for unrecorded liabilities and ensuring that expenditures are properly recorded.

8.25

Argus did not have separation of duties. Different people should have authorized the copying services, approved the bills for payment, and coded them to projects. A supervisor should have been reviewing the expenses and comparing them to the budget.

8.26

The verbal inquiry procedure might produce knowledge of employee‘s responsibilities to authorize purchases of script copies, receive them, approve payment, and code invoices to projects.

8.27

Given Beta Magnetic‘s poor internal controls, it is possible that Martha would never have been caught. However, if the company ever contacted employees about their health claims, they would have revealed the fictitious charges.

8.28

If Martha had taken a mandatory vacation, her replacement would probably have questioned the billings from unknown physicians. If the billings stopped, the sharp drop in insurance costs for that period would likely be questioned by Martha‘s superior and the fraud may be uncovered.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 8.29

a. b.

Incorrect Incorrect

Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

b. c.

Incorrect Correct

Incorrect

8.32

a. b. c. d.

Incorrect Incorrect Correct Incorrect

8.33

a. b. c. d.

Correct Incorrect Incorrect Incorrect

The completeness assertion is very important in the audit of liabilities. This would restrict a company‘s ability to do business. Auditors are normally not concerned with whom the client‘s vendors are. Competitive bids are normally required for only large purchases.

8.34.

Incorrect

Correct

Incorrect

Correct

Incorrect

Risk assessment procedures are varied, but obtaining an understanding is typically achieved through inquiry and observation. Tests of automated application controls can often be accomplished through system tests and a test of one instance. Tests of segregation of duties are typically achieved through observation and inquiry. When testing the operating effectiveness of authorization, it is often necessary to select a sample of transactions to obtain documentation of authorization. A decline in the current ratio indicates either a decrease in current assets or an increase in current liabilities, not a potential understatement of liabilities. A decline in the percentage of A/P relative to total liabilities may indicate an understatement of A/P. A decrease in the accounts payable turnover ratio may be indicative of slower payment of payables or possible overstatement, but not an understatement of payables. An increase in the A/P balance is not an indicator of understatement.

8.30

8.31

8.35

Cash disbursements are an important part of the cycle. Although similar to sales because they are shipped out, purchase returns are considered part of the acquisition and expenditure cycle because they affect accounts payable. Although similar to purchases because they require a receiving report, sales returns are considered part of the revenue and collection cycle because they affect accounts receivable. Prepaid Insurance is one of the many accounts in the acquisition and expenditure cycle. Cost of goods sold should be matched with sales by using inventory to record cost of goods not yet sold. Research and development is a period expense that is recorded as incurred. Depreciation allocated over time on a systematic and rational basis except in the unusual situation in which units-of-production depreciation is used. Sales are recorded when earned. Purchase orders may contain multiple items shipped from different warehouses or at different times. This would result in separate invoices. Companies often reorder the same item from a vendor multiple times. Invoices should have unique numbers. Thus, if the same invoice number is used multiple times, this may be an indicator of some type of fraud. If a company places multiple orders with a vendor on the same day (perhaps from different departments), multiple invoices may be send on the same day. Overstates net income in the period of capitalization. Overstates net income. Has no effect on net income. It overstates cash and payables. Since a & b overstate net income and c does not, all of the answers above are not correct

8.36

a. b. c. d.

Incorrect Incorrect Incorrect Correct

These duties should be separated. This would not necessarily prevent a duplicate payment. The voucher date may be several weeks before the payment is due. Cancellation of vouchers (by marking them asPAID) prevents their use a second time.

8.37

a. b. c. d.

Incorrect Incorrect Incorrect Correct

The requisition would not result in the improper delivery. No cash is received at Lake. No inventory is ordered for Lake or entered into Lake‘s inventory records. Nobody at Lake was reviewing purchase orders to notice the delivery and payment by another party (Budd‘s relative‘s store). This deviation caused no direct loss to Lake, but it is a misuse of Lake‘s pricing agreements with its vendors and puts Lake at risk.

8.38

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

If the liability is unrecorded, it would not be on the trial balance. Auditors may be able to determine that cash disbursements in the subsequent period are paying liabilities of the period under audit. This is a cutoff test; (b) is a more direct test. This is only an indirect test; (b) is a more direct test.

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

Approvals do not necessarily result in purchases or debits to the inventory. Purchase requisitions may not represent the actual amount received. Invoices supply relevant information about the quantities purchased and the prices paid. Purchase orders do not always represent the actual amount received.

8.42

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This would have ensured a proper count of the tables. This would insure the invoice was for the amount received. This would insure the check was for the amount received. The purchase order and requisition would both show 84 tables.

8.43

a. b.

Incorrect Incorrect

Correct

Incorrect

The check signer is probably not familiar with all the vendors. This is possible, but the maintenance costs may not have been unusual (i.e., the costs before the fraud were below budget). Vendors should be approved by an independent purchasing department before an order can be placed. Since a and b are incorrect, all of the above are not correct

Incorrect

8.39

8.40

8.41

8.44

This is often performed before the balance-sheet date. This is often performed before the balance-sheet date. The search for unrecorded liabilities generally depends upon using accounting records created in the period after the year end. This is often performed before the balance-sheet date. Some liabilities may be incurred but not invoiced by the vendor. Purchase orders do not normally incur liabilities. The receiving reports are the population that contains the record of all goods received for which liabilities should be recorded. The invoice or receiving report must be examined to determine when the liability occurred.

Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions. Cost of goods sold is generally audited by tests of controls, analytical procedures and substantive tests of transactions. Supplies expense is usually audited in connection with supplies inventory.

8.45

8.46

8.47

8.48

8.49

Correct

The auditor examines the specific charges to determine potential litigation.

a. b.

Correct Incorrect

c. d.

Incorrect Incorrect

Property tax expense is audited in conjunction with accrued property taxes. Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions. There‘s no asset directly related to R&D. The auditor examines the specific charges to determine potential litigation.

a, b,.

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Although auditors are always concerned about existence and rights and obligations, these issues usually arise because of errors in the accounts. However, it is unlikely that management would intentionally add nonexistent liabilities, or accounts for which management has no obligation to pay. Completeness is the most important assertion in this cycle. The hiding of liabilities is a primary concern for all auditors in the liability and expense areas. Supplies expense is generally audited in connection with supplies inventory. Valuation and allocation would be the second best answer since recording liabilities at an amount less than its proper value might be a ploy management can use to ―cook the books‖. However, auditors are usually more concerned about unrecorded liabilities affecting the completeness assertion. Testing occurrence would require vouching from the vouchers recorded in the voucher register to receiving reports. This test ensures that liabilities generated by the receipt of goods are recorded in the voucher register. This does not test classification, which would require examining the chart of accounts. This does not test cutoff, which would require comparing the date of the receiving report to the date recorded. Clerk 1 reviews vendor invoices, therefore clerk 1 has access to the vender invoices. Opening the mail would not provide any additional access or violate the separation of duties that already exist. Clerk 2 has recordkeeping responsibilities. Reconciling the accounts payable account and the general ledger would not violate the separation of duties. Clerk 3 has recordkeeping responsibilities. Providing a signed check to Clerk 3 provides the clerk access to an asset and violates the separation of duties. The treasurer may use a stamp for signing checks as long as the stamp is controlled. Whether the Treasurer uses a stamp or manually signs the check does not change the treasurer‘s responsibility as the authorization for the payment. A reduction in returns would not provide evidence regarding the valuation of the account payable. A purchased item listed on the monthly vendor statement should be included in the accounts payable. If it cannot be traced to the accounts payable record, the vendor account will be understated. Customer returned goods would affect accounts receivable, not accounts payable. Cash received form customers would affect accounts receivable, not accounts payable.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 8.50

Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds 1.

Purchases and accounts payable are authorized to assure compliance with company policy (authorization).

For a sample of cash disbursements, vouch to approval signatures on invoices, receiving reports and purchase orders.

Costs and expenses might be incurred that are not properly supported.

Select a sample of current-year debits in accounts (e.g., inventory, fixed assets, expenses), and vouch them to supporting documents.

Liabilities are recorded at the appropriate quantity and description (accuracy).

Select a sample of invoices and agree them to the receiving report. Observe receiving department counting receipts.

Vendors could bill for quantities greater than the amount actually shipped, overstating costs or expenses.

Observe the client‘s inventory account and test the reconciliation of the count to the perpetual inventory.

8.51

Liabilities are recorded for actual purchases at the appropriate amounts (accuracy). b.

Observe client personnel making comparisons. Examine initials for approval. Review correcting journal entries that result from the comparison.

Purchases or other liabilities may be recorded for transactions that didn‘t exist or at incorrect amounts.

Reperform comparison on a test basis.

Journal entries are authorized and prepared in accordance with generally accepted accounting principles (accuracy, classification).

Examine entries for approval initials.

The company might override controls to create fraudulent entries.

Select a sample of recorded journal entries and reperform calculations and review for appropriate accounts.

Unrecorded Liabilities Procedures a.

The fact that the client made a journal entry to record vendors‘ invoices that were received late should simplify the auditors‘ audit for unrecorded liabilities and reduce the possibility of a need for a further adjustment, but the audit is nevertheless required. If the client has not journalized late invoices, the auditors are compelled in their testing to substantiate what will ultimately be recorded as an adjusting entry. In this examination, the auditors should audit entries in the voucher register, for the year being audited, to ascertain that all items, which according to dates of receiving reports or vendors‘ invoices were applicable to that year, have been included in the journal entry recorded by the client.

No. The auditors should obtain a letter in which responsible executives of the client‘s organization represent that to the best of their knowledge all liabilities have been recognized. However, this is done as a normal audit procedure to afford additional assurance to the auditors, and it does not relieve the responsibility for doing other substantive audit work.

Whenever auditors are justified in relying on work done by an internal auditor, they should curtail (but not eliminate) their own audit work. In this case, the auditors should have ascertained early in the examination that Ozine‘s internal auditor is qualified by being both technically competent and objective. Once satisfied as to these points, the auditors should discuss the nature and scope of the internal audit program with the internal auditor and review the working papers in order that the auditors may properly coordinate the audit program with that of the internal auditor. If the Ozine internal auditor is qualified and has made tests for unrecorded liabilities, the auditors may reduce further audit work in this audit area.

In addition to the 2011 voucher register, the auditors should consider the following sources for possible unrecorded liabilities: 1. 2. 3. 4. 5. 6. 7. 8.

Unentered vendors‘ invoice file. Status of tax returns for prior years still open. Discussions with employees. Representations from management. Comparison of account balances with preceding year. Examination of individual accounts during the audit. Existing contracts and agreements. Board minutes.

9. 10. 11. 12. 8.52

Attorney‘s bills and letter of representation. Status of renegotiable business. Correspondence with principal suppliers. Audit testing of cutoff date for reciprocal accounts (e.g., inventory and fixed assets).

Accounts Payable Confirmations a.

The accounts payable audit procedures should be directed toward searching for proper inclusion of all accounts payable and ascertaining that recorded amounts are reasonably stated because the primary audit purpose is to reveal any possible material understatements. The principal objectives of the accounts payable examination are: (1) (2) (3)

Clark and Kent are not required to use accounts payable confirmation procedures. For accounts payable the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts payable balance. Although not required, the accounts payable confirmation is often used. The auditor might consider such use when: (1) (2) (3) (4) (5) (6)

To determine the adequacy of internal control for processing and payment of invoices. To prove that amounts shown on the balance sheet are in agreement with supporting accounting records. To determine that liabilities existing at the balance-sheet date have been recorded.

Internal controls are weak. The company is in a ―tight‖ cash position and bill-paying is slow. Physical inventories exceed general ledger inventory balances by significant amounts. Certain vendors do not send statements. Vendor accounts are pledged by assets. Vendor accounts include unusual transactions.

When auditing accounts payable the auditor is primarily concerned with the possibility of unrecorded payables or understatement of recorded payables. Selection of accounts with relatively small or no balances for confirmation is the more efficient direction of testing since understatements are more likely to be detected when examining such accounts. When selecting accounts payable for confirmation, the following procedures could be followed: 1.

Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances and so on.

Use a sampling technique that selects items based on criteria other than the dollar amount of the items (e.g., select based on terminal digits, select every nth item based on predetermined interval (etc.).

Design a statistical sampling plan that will place more emphasis on selecting accounts with zero balances or relatively small balances, particularly when the client has had substantial transactions with such vendors during the year.

Select prior-year vendors who are no longer used.

Select new vendors used in the subsequent years.

Select vendors that do not provide periodic statements.

Select accounts reflecting unusual transactions during the year.

8. 8.53

Search for Unrecorded Liabilities 1.

List the unmatched vendor invoices and determine when the goods were received, focusing on the unmatched receiving reports and receiving reports prepared after the year-end. Determine which invoices, if any, should be recorded.

Review the year-end unmatched receiving reports and determine whether entries are recorded in the proper accounting period. Select a sample of cash disbursements from the accounting period following the balance-sheet date. Vouch them to supporting documents (invoice, receiving report) to determine whether the related liabilities were recorded in the proper accounting period.

8.54

Select accounts secured by pledged assets.

Study IRS examination reports for evidence of income or other taxes in dispute, and decide whether actual or estimated liabilities need to be recorded.

Confirm accounts payable with vendors, especially regular suppliers showing small or zero balances in the year-end accounts payable. These are the ones most likely to be understated. (Vendors‘ monthly statements controlled by the auditors also may be used for this procedure.) Be sure to verify the vendors‘ addresses so that confirmations will not be misdirected, perhaps to conspirators in a scheme to understate liabilities.

Study the accounts payable trial balance for indications of dates showing fewer payables than usual recorded near the year-end. (A financial officer may be delaying the recording of vendor invoices.)

Use a checklist of accrued expenses to determine whether the company has been conscientious about expense and liability accruals including accruals for wages, interest, utilities, sales and excise taxes, payroll taxes, income taxes, real property taxes, rent, sales commissions, royalties, and warranty and guarantee expense.

When auditing the details of sales revenue, pay attention to the terms of sales to determine whether any amounts should be deferred as unearned revenue. Inquiries directed to management about terms of sales can be used to obtain initial information, such as inquiries about customers‘ rights of cancellation or return. The terms may signal the need for deferred revenue accounting.

10.

Perform analytical procedures appropriate in the circumstances. Calculate and compare the gross margin percent of the current year to that of prior year(s), and compare important expense account balances to those of prior years to notice any that this year appear to be too low.

Fictitious Vendors, Theft, and Embezzlement In this case, let your initial objective be to select one vendor for investigation. Instead of a ―tests of controls‖ section, name the one vendor you would select from those in Exhibit 8.51-1 and tell your reasons. In the ―test of balances‖ section, tell how you would investigate the situation. In the ―discovery summary‖ section, speculate about how your investigation might reveal the culprit.

Audit Approach Objective: Select one vendor for investigation, and try to obtain evidence of purchasing at inflated prices. Control: Purchasing operations should be performed under rules and procedures designed to motivate purchasing agents to buy at the best prices available from competing vendors. Competitive bidding should be required unless conditions make the best prices available without bid. However, purchasing agents should have flexibility within operating procedures to move quickly to obtain the best balance of quantities, delivery terms, and prices as events dictate. Thus, they may not always obtain competitive bids. A higher manager level should supervise and review the results of purchasing activity on a regular basis, perhaps reperforming some price-obtaining actions occasionally to determine whether the agents are achieving efficiency. Such review might also involve selecting odd situations for extensive review. Tests of controls: The one vendor selected is Orion Corp. Key reasons for this selection are:  Volume is high and has increased almost 1000 percent, more than for any other vendor.  Last bid was obtained in 2007, older than other vendors‘ bids.  The percent purchased on bid is lowest among those bids.  Collins, the manager, is in charge.  Collins purchases from several vendors without bids. Audit of balance: Investigation of purchases from Orion: 

Review purchase invoices to determine unit prices for paper.



Compare unit prices with other suppliers.



Interview other suppliers and their salespersons to try to determine whether Collins solicited kickbacks.



Review bid records to determine the dates of submitted bids and bid prices.



Examine Collins‘ personnel file. Investigate references if they were not consulted earlier. Might investigate again with more determination to notice telltale signs.



Conduct interviews with Collins and other purchasing agents under a front of learning about purchasing procedures. Carefully seek information or impressions about Collins relations with Orion. 

Inquire at secretary of state office for names of Orion incorporators to see if Collins is connected. Look up officers in national executives directory to see if she is listed as an officer of Orion.



Covertly observe Collins‘ lifestyle and spending habits. A ruse might be used to get information about Collins‘ bank balance and activity. (Overt action such as subpoena should not be used until clear evidence of guilt is available.)

Discovery Summary If Collins is taking kickbacks in return for causing Bailey to pay higher prices, the price comparison information should show evidence. If this is the case, the other procedures should also bear fruit—past employment history problems, police record, derogatory gossip from co-workers, more wealth than justified by salary, maybe even a direct connection with Orion.

Collins has plenty of ―room‖ to cause Bailey a significant financial drain. Purchases from Orion were $1,220,000 over the last two years, and about $500,000 of supplies and sundries without bid from other suppliers. If the overpricing to Bailey were 10 percent of all these purchases, it could amount to $172,000 for two years‘ ―work.‖ P.S. The title of the case ―Purchasing Stars‖ is a clue to the solution

8.55

8.56

(Orion)

Bidding Process a.

While it might seem logical that the vendors would split the bids fairly evenly over time, in the real world, this is not usually the case. As a matter of fact, an even split would likely be a red flag. (c). Generally, one vendor turns out to be a low bidder the majority of the time. The fact that Wright has been the winning bidder about half the time is not by itself a red flag.

The situation in which Wright has been the last bidder in each of the winning bids changes the situation dramatically. When the final bidder is the winning bidder the majority of the time, it may be an indication of an information leak. The contracts being bid are worth a considerable amount of money, and bribes paid for information must be considered. We can control this by keeping the bids locked and unopened until the bidding deadline has passed. Bids should be opened by someone other than the purchasing agent and should be opened and recorded by two people.

It is unusual for venders to split contracts in such a manner. This may be indicative of collusion among the venders. Controls might include having more than three vendors and having a different mix of vendors bid on each contract. A detailed proposal listing all components of the bid may detect collusion. Vendor approvals should be reviewed periodically for changes in management or ownership (it is possible that one company has purchased another and may be operating under two different names).

This may or may not be a problem. Bids may be awarded on criteria other than just price. Delgado may have been able to meet a deadline other bidders could not or might have special expertise that make him preferable on a specific job. The auditor should inquire of management about the criteria for awarding these bids. Controls might include documentation with the bids regarding the rationale for choosing a specific vendor. This documentation should be reviewed and approved by an appropriate member of management.

Grounds for Dismissal Audit Approach Objective: To detect the fraudulent hiring of a consulting firm. Control: The contract should have been approved by someone above Doe‘s level. Payments should not have been made without such approval. After being signed, checks should be mailed directly from the treasurer‘s office. Test of controls: Examine disbursements for indication of authorization. Endorsements on checks can be examined for double signatures. Audit of balance: Tests of charges to the capital account should reveal the large amount of expenses being capitalized. In addition to vouching these charges, auditors should inquire about whether they are properly capitalized as long-term assets.

Discovery Summary Company employees in charge of capital projects began noticing the large charges. In March 2001, Doe and her husband were named in a $2.4 million civil judgment, the largest fraud in the history of King County, Washington. The settlement required a list of possessions the Does had acquired. The 19-page list contained 489 items. Cars, pianos, and other items were sold at auction and netted The Coffee Co. about $1.8 million. Doe was a compulsive shopper. The police reported there was only a small path through the rooms of her house because boxes of her purchases were stacked to the ceiling. Red flags that should have tipped off her supervisor and co-workers included:  Doe was evasive and never satisfactorily answered questions about FCC.  When the supervisor asked to meet with FCC, he was told they were working out of the office.  FCC was not registered in the State of Washington or listed in telephone directories.  FCC‘s mailing address was a P.O. box. The physical address was Doe‘s residence.  Doe requested special handling for FCC checks whereby she picked them up personally. 8.57

Audit Simulation: Audit the PP&E and Depreciation Schedule a.

The Computer B system is depreciated for a full year ($583,000), but depreciation should be calculated for only eight months. Correct amount is $389,000. The depreciation on the press should be $75,000 instead of $150,000. Somebody doubled the depreciation expense for this year. Accumulated Depreciation Cost of Goods Sold Inventory General and Admin. Expense

269,000 67,500 7,500 194,000

The best way to approach this requirement is to write a procedure for each assertion. Building 2 Existence: Inspect the building to determine that it is in ―productive use‖ (evidence of existence). Rights (ownership): Vouch the legal title papers and recorded deed for evidence of ownership. Valuation: Vouch the contractor‘s billings and the payments for evidence of appropriate cost valuation. Presentation and disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Computer B system Existence: Inspect the computer and observe it in operation. Rights (ownership) and valuation: Vouch purchase and title documents (ownership and cost valuation). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for installation and testing costs that should be capitalized (evidence of completeness of recording asset cost).

Auto 2 Existence: Inspect the auto and observe it in operation. Rights and valuation: Vouch purchase and title documents (ownership and cost valuation). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for typical additional costs (e.g., tax, title, and license) that should be capitalized (evidence of completeness of recording asset cost). c.

8.58

The loss on the sale of the Computer A system should be $542,000 ($5,000,000 - $3,958,000 $500,000). The gain on the sale of Auto 1 (fully depreciated) should be $1,000. The cash flow from investing activities should show cash inflow from sale of assets in the amount of $501,000. There should be cash outflow for purchase of assets in the amount of $45,522,000.

PP&E Assertions and Substantive Procedures 1.

Rights evidence: d.

Existence evidence: g.

Examine deeds and title insurance certificates.

Physically examine all major property and equipment additions.

Valuation evidence: b. Review the provision for depreciation expense and determine whether depreciable lives and methods used in the current year are consistent with those used in the prior year.

8.59

Assertions and Substantive Procedures for Property, Plant, and Equipment (PP&E) a.

Valuation, Existence

Valuation

Valuation and Allocation

Existence

Completeness

Valuation and Allocation

Rights and Obligations

Rights

Valuation

8.60

CAATS Application—PP&E a.

The information needed to reconcile subsidiary detail records to general ledger balances:  Asset type.  Location code.  Cost.  Accumulated depreciation, end of year. The task of footing the subsidiary ledger and comparing the recalculation to the general ledger balance(s) does not complete the audit of fixed assets. Additional evidence is needed to be persuaded of existence of the assets (observation), valuation (vouching invoices, recalculating depreciation), completeness (vouching and tracing transactions dated around the year-end), and presentation and disclosure (in-use-status, inquiries about hypothecation, liens).

8.61

The assistant will also need to know the asset number, description, as well as asset type and location code mentioned in (a).

Search for Unrecorded Liabilities a.

Audit plan Procedure

Performed by

Ref

1. Obtain a trial balance of recorded accounts payable as of year-end and vouch to receiving reports to ensure goods were received in the current year

2. Select a sample of cash disbursements from the accounting period following the balance-sheet date. Vouch disbursements to supporting documents (invoice, receiving report) to determine whether the related liabilities were recorded in the proper accounting period.

3. Send confirmations (a) to creditors with small or zero balances (b) to creditors with whom the company has done significant business

3. Inquire of client personnel about their procedures for ensuring that all liabilities are recorded.

4. Obtain a list of unmatched vendor invoices and review receiving reports to identify when the goods were received.

5. Trace the unmatched receiving reports to accounts payable, and determine whether items recorded in the next accounting period need to be adjusted.

Adjusting journal entry Vouchers Payable Rent Expense

53,000 53,0001

To reverse January rent expense recorded in December Miscellaneous Expense Cost of Goods Sold Office Expense Vouchers Payable

6,300.00 5,932.892 8,644.863 20,877.75

To record unrecorded liabilities 8.62

Identifying Assertions, Control Activities, and Substantive Procedures

Ques a. b. c. d. e.

Assertion E G A B B or F

Control Activity G F A F C

Substantive Procedure B B A A or B A, B, or C

May omit if students assume the charge was made to prepaid rent. This assumes that the company counted inventory correctly, which would lead to an understatement of COGS. If not, the entry should be to inventory, presuming the goods are not yet sold. 3 Only one month was accrued (October) for cleaning, so both November and December s/b accrued. 1-199 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2

8.63 a.

1. Please see the IDEA Workbook pages 169-175 for detailed solutions.

$501,516. Please see the IDEA Workbook pages 169-175 for detailed solutions.

As a result of these tests, control risk related to the authorization of purchases is elevated. The accounts most affected by this are the occurrence of purchases and rights & obligations related to accounts payable.

Setting Up Data in IDEA 1. Create a managed project in IDEA

2. Obtain the Purchases 2020 – 4th Q, Cash Disbursements 2020 – 4th Q, and Approved Vendors databases from Connect. Copy the required data into the project file within documents->My IDEA Projects-> Project name (ELM Company Ch 8 in this example).

3. Refresh the file list in IDEA to show the databases within your project:

8.64 Summarizing Purchasing Data with IDEA. You have been assigned the task of understanding the client‘s purchasing habits, including their use of authorized vendors and payment time frames, and you must use IDEA to gather this information. a. Determine the total dollar amount ordered from each vendor. What companies are the three largest vendors by dollar amount? How would this information assist an auditor in planning the audit? With the Purchases 2020 – 4th Q database open, Summarize the ORDPRCE by VENDNO. You may create a database or just create a result.

You can double click on the ORDPRCE_SUM column to sort order by vendor:

Vendors 1553, 3777, and 4221 are the three largest vendors. The auditor can see that these three vendors account for over 90% of all purchases, indicating a concentration of supply chain risk. Optionally, you can join the Approved Vendor database with the Orders by Vendor database by VENDNO to obtain the names of these vendors:

b. Determine what products are ordered most often. What item is ordered most often? How might this information affect the audit? While back in the Purchases database, Summarize ORDAMT by PARTNO

Depending on whether you consider number of orders (NO_OF_RECS) or the sum of the quantity ordered (ORDAMT_SUM), the answer may vary. Based on the number of orders, product J9340 was ordered 14 times and S1462 was ordered 6 times. However, in terms of number of the products orders, F2995 is the most ordered item. This information will help the auditor identify higher volume parts, which in conjunction with an analysis of costs will enable the auditor to focus testing on material parts.

In Connect, this question asks for the total Order Price for the item ordered most often. A summarization including that shows the answer is $4868.10.

c. Determine the accounts payable amount for each vendor as of March 31. What companies have the three largest accounts payable balances? How would this information assist an auditor in planning the audit? There are multiple ways to perform this calculation, but a useful one is to extract a database and name it Accounts Payable. Perform and analysis->direct extract and use the criteria that PAYAMT=0, indicating that the invoice is not yet paid. Note that the company only fully pays their invoices (or takes discounts where available – which will be tested separately).

Determining the three largest payables requires performing a summarization, as done in parts a. and b. 1-205 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The resulting data (when sorted descending by double clicking on the column name) indicates that vendor numbers 3777, 1553, and 4221 are the largest three vendors. The analysis could also have been performed using VENDNAME. Although the biggest risk for A/P is completeness, it is nonetheless useful to know the largest vendors, particularly if a client is facing cash constraints and may be unable to pay on time. Further, if the largest payables to do not correspond with the most used vendors, this can also indicate potential classification or payment issues. d. Were any orders made to vendors not on the approved vendor list? How would this information assist an auditor in planning the audit? In step a., a database named Orders by Vendor was created, and the optional step of joining that database with the Approved Vendors was demonstrated. The resulting data shows that there were two orders made to vendors not on the approved list. Vendors 1101 and 1652 were not on the approved list. Although the total amount of the orders is immaterial (~$6,600), this is nonetheless a risk because it could represent either fraud or lack of lack of both preventative and detective controls surrounding authorization controls in the purchasing cycle, increasing control risk. 1-206 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

e. Were there any discounts available that were not taken? Why is this important? To determine the total number of discounts, a direct extraction can be performed where the possible discount exists, but the payment amount is not less than the invoice amount.

The results indicate that the company did not take 6 discounts, all to the same vendor, and all large amounts. Because the real interest rate on failing to take discounts is large, it does not make economic sense to miss a discount unless there is cash flow difficulty. Most companies could use an open line of credit if necessary to obtain the payment discount. Thus, evidence of repeated, large discounts not taken is evidence for the auditor of potential short-term cash constraints. 1-207 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

f. Were there any vendors paid late? Why is this important? The background information for the purchasing cycle indicates that vendor payments are due within 30 days. To find late payments, a direct extraction using the @AGE function will be appropriate. The @AGE function has a syntax of @AGE (later date, earlier date). To find late payments, find values greater than 30, as shown below.

An analysis of the resulting table indicates that there are 10 late payments, including two material payments. Again, this can indicate potential cash flow problems or poor controls surrounding the payment of invoices. g. Were there any items that did not pass inspection? Why is this information important to the auditor? 1-208 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

As with most control testing in IDEA, a direct extraction can be used to find exceptions to a condition. For this extraction, items that have been received, but did not pass inspection must be found.

The finding that 22 purchases did not pass inspection (although four appear to not require an inspection) indicates that the company appears to have a control weakness in their inspection process. Several items marked as rejected appear to have remained in purchases, and many other items appear to not have been inspected at all. 8.65 1-209 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Tests of Controls in the Purchasing Cycle with IDEA. You have identified relevant controls for several assertions within the purchasing cycle, and you must use IDEA to perform several tests of controls. a. Are all checks accounted for? If there are checks that are not accounted for, how would this affect the audit? To determine if all checks are accounted for, the auditor would use a gap detection procedure, which is common in testing for the completeness assertion. In IDEA, this is performed using analyze->gap detection. Be sure that the Cash Disbursements 2017 -4th Q database is selected for this procedure. Because any missing check is a concern, use a gap increment of 1. No additional criteria are necessary for this exercise. The gap detection procedure gives you the option of creating a database or a result. Either will work. The results are selected in the Properties box on the right side of the interface after they have completed.

The results indicate that there are 306 missing items. However, 300 are in a single sequence and most likely do not represent missing checks. The auditor would need to verify with the 1-210 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

client and with a bank statement that the checks were not written. If the checks are preprinted, the auditor would request documentary evidence that the checks remain unwritten in the client‘s possession. There are also six individual checks missing. The checks represent potential unrecorded purchases, and also represent a control deficiency related to the completeness of recorded purchases. Note: Upon completing this, to return to the data in IDEA, click the data item that is circled in green in the above screenshot. b. Are there any duplicate check numbers? If there are duplicate checks, how would this affect the audit? For this test of control related to the existence of purchases, use the analysis->duplicate key>detection procedure in IDEA. Select the field CHECKNO.

Depending on interpretation, either 3 or 6 duplicate checks were written during the year. Unique check numbers are an important control for the existence/occurrence of purchases, but if checks are not unique, it can also lead to problems with the completeness of recorded 1-211 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

cash disbursements and purchases. The auditor would need to investigate why these duplicate checks were produced, and would also want to vouch the checks to a bank statement and other supporting documentation. c. Are there any payments to vendors not on the approved vendor list? If there are checks to such vendors, how would this affect the audit? This exercise is very similar to 8.60 d., but has a different objective. Whereas searching for unauthorized orders is a concern with authorization of purchases, checks written to unauthorized vendors can represent either fraudulent payments or problems with authorization of purchases. However, if a client uses the same account to pay suppliers and operating expenses, this test can be problematic. To test for payments to unapproved vendors, the auditor will use the analyze->join procedure while the Cash Disbursements 2020 -4th Q database is selected. Because the secondary database is Approved Vendors, students should search for items with no secondary match. Note that whenever possible, it is useful to join on a numerical field instead of a character. Students will often try to join on VENDNAME and may get a different (and incorrect) answer because of differences in capitalization, field lengths, etc.

Two checks have been written to unauthorized vendors. The auditor should follow up and vouch the checks to documentary evidence to verify that the purchases are valid. These payments represent a control deficiency related to authorization of payments (and purchases). Note that Connect asks for the dollar amount of payments to unauthorized vendors. Although students could easily add this since only two checks meet this criteria, summary statistics are always available in IDEA by clicking ―field statistics‖ in the properties window. The total dollar amount of these checks is $7,531.

d. Were any checks voided? Were any checks written to cash or bearer? How would this affect the audit? Voided checks were found in 8.61 c – there were two voided checks. As long as the auditor is able to vouch to the voided checks, this will not affect the audit in any significant way. However, if the voided checks cannot be located, this represents a control deficiency related to completeness of cash disbursements. To find checks written to cash or bearer, perform a direct extraction. In the equation editor, a useful function is @ISINI, which is a text comparison function that is not case sensitive. The format of the function is shown below, with a compound test for either cash or bearer.

The results indicate that there were two checks written to cash during the quarter. The auditor should vouch the checks to supporting documentation and examine endorsements on the cleared checks as they represent high fraud risk.

As in part c. above, to obtain the total dollar amount of checks written to cash, use the field statistics in the properties window. The net value of the 2 checks are $7,092.

8.66 Testing for Unmatched Invoices. A concern in all audits is the risk that payments are made that do not represent valid expenses. One common test is to match payments to valid invoices, and you must use IDEA to perform this test. Match the paid invoice numbers in the purchases data set with the invoice numbers in the cash disbursements data set. Are there unmatched invoices from the purchases data? To perform this test in IDEA, the auditor would join the Purchases 2017 – 4th Q database (primary database) with the Cash Disbursements 2017 – 4th Q database (secondary database) and use the criteria of no secondary match. For this exercise, the auditor would only be looking for invoices marked as paid. Thus, a criteria needs to be entered by clicking the equation editor calculator button

The auditor would match on the INVNO field.

The results indicate that there are eight recorded payments totaling $147,615 (using field statistics in the properties window to obtain the amount) with no match in the cash disbursements journal. There are many possible reasons for this – incorrectly recorded invoice numbers or payments recorded but not actually made are two more common explanations.

Are there any disbursements with invoices that do not match to the purchases data? To perform this test, reverse the order of the primary and secondary databases in the first part of this problem. To do this, perform the analysis->join command with the Cash Disbursements 2017 – 4th Q database selected. Note that for this command, no criteria is necessary because all items in the primary database represent payments.

The results indicate that there are 44 disbursements not in the Purchases journal totaling $360,139.

What are possible causes for discrepancies between these data sets? How would the auditor address these discrepancies? An examination of the list of disbursements without associated entries in the purchases database indicates that most of the vendor names appear to be for services. Thus, the auditor would need to obtain a list of authorized service vendors prior to reaching any conclusions. However, it does appear that some payments to known suppliers are on the list, as well as payments to cash. The reasons for these discrepancies range from mistyped invoice numbers to payments for goods not purchased by the company or unrecorded purchases. Regardless, unmatched cash disbursements increase control risk surrounding the occurrence and completeness or purchases and cash disbursements.

APPENDIX 8C The Payroll Cycle SOLUTIONS FOR REVIEW CHECKPOINTS 8C.1

The functions in a payroll cycle include:      

8C.2

Personnel and labor relations - hiring and firing (authorization). Supervision - approval of work time (authorization). Timekeeping and cost accounting - payroll preparation and cost accounting (recordkeeping). Payroll accounting - check preparation and related payroll reports (custody of cash). Check signing (custody). Payroll distribution - actual custody of checks and distribution to employees (custody of cash).

In a payroll cycle, the functional responsibilities which should be separated include: 1. 2. 3. 4. 5.

Personnel or labor relations department. Supervision. Timekeeping and cost accounting. Payroll accounting. Payroll distribution.

8C.3

When employees are terminated, the employee should be interviewed by the personnel department, who can then remove them from the payroll files. Separation of responsibility for handing out paychecks from authorization and record keeping can reduce the incentive for supervisors to keep terminated employees on the payroll. Labor cost analyses also reduce incentives for supervisors to have too many employees listed in their departments. Finally, W-2s should be sent directly to the employees‘ homes so they can spot any fictitious wages.

8C.4

A walkthrough of a personnel and payroll transaction would include discussions with each person handling personnel and payroll records. The following illustrates the steps and documents collected. Steps Hiring—personnel department Deductions—personnel department Timekeeping Shops Cost distribution Accounts payable Cash disbursement

8C.5

Document(s) Collected Authorization to hire and rate assignment Personnel forms, employee authorization for deductions (e.g., W-4 form) Clock card Production time ticket Labor distribution work sheet Payroll voucher Payroll checks

If the payroll is processed by computer, the clock cards and production time tickets would be traced to batch control in the timekeeping and production departments, to data preparation (input), to edit and validation error reports and other computer output indicating control, and finally to computer-prepared checks, labor distribution reports, and summary general ledger entries.

Important documents in employee‘s personnel files:  

Employment application. Background investigation report.

   

8C.6

8C.7

Notice of hiring. Job classification with pay rate authorization. Authorizations for deductions (e.g., health insurance, life insurance, retirement contribution, union dues, W-4 form for income tax exemptions). Termination notice, if applicable.

Prevent or detect payment to a fictitious employee: 

Paychecks prepared only for persons with employment authorization from the personnel department.



Paychecks prepared only for persons with approved work attendance, time.



Paychecks distributed only in person to persons identified as employees (or by electronic transfer to validated employee bank accounts).



Payroll register or list confirmed by the supervisor after paychecks are prepared or distributed.

Employees are expected to complain if they are not paid!

The common errors and frauds in the personnel and payroll cycle are a) Recorded employee transactions are not valid (fictitious employee), b) Recorded attendance transactions are not valid (fictitious hours), and c) Incorrect cost accounting classification for labor.

Auditors look for separation of duties, proper authorizations and good reconciliations to prevent or correct these errors or frauds. Auditors should be alert to a supervisor having too many incompatible responsibilities (e.g., hiring, authorization of hours, authorization of pay rate, distribution of pay checks and dismissal--only authorization of hours is a proper responsibility).

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 8C.8

8C.9

Incorrect

Correct

Incorrect

Correct

It is an appropriate control to have the payroll department supervisor examine authorization forms for new employees to ensure the information as been properly recorded in the payroll system. It is an appropriate control for the payrool department supervisor to compare the batch total with the payroll register to ensure that the appropriate number of payments have been made. The payroll department should be independent of the personnel department, which would be responsible for authorizing all payroll rate changes for the employees of the entity. A supervisor would be authorized, however, to initiate requests for rate increases for supervised employees. A department supervisor should have approval on all employees hired into their department.

The personnel department provides the authorization for payroll-related transactions (e.g., hiring, termination, and changes in pay rates and deductions). IncorrectThe treasurer‘s department is not a part of the pay rate process.

8C.10

8C.11

8C.12

8C.13

8C.14

Incorrect

Correct

c. d.

Incorrect Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

The controller is the chief accountant and manages the recordkeeping processes and should not have any authorization responsibilities. Payroll is a recordkeeping function and should not have authorization over pay rates. A generalized program would not be sufficiently sophisticated to test this procedure. In a manual payroll system, a paper trail of documents would be created to provide audit evidence that controls over each step in processing were in place and functioning. One element of a computer system that differentiates it from a manual system is that a transaction trail useful for auditing purposes might exist only for a brief time or only in computer-readable form. This may be true, but there is not enough information about built-in controls. This is a real-time system as records are updated when employees record their time. The payroll clerk has access to recording and custody. Unclaimed pay should be given to the treasurer. Under a cash payroll system, the receipt signed by the employee is the only document in support of payment. The signed receipt is essential to verify both occurrence and accuracy of payment. This would not be applicable to cash payroll. An absence of an approved time record would prevent the employee being paid. This is a good by-product of the policy, but it is unlikely that real employees would fail to pick up their checks for several weeks. This procedure would not prevent another employee from picking up the check. A follow-up of unclaimed checks may result in identification of fictitious or terminated employees, thus eliminating an employee‘s opportunity to claim a paycheck belonging to a terminated employee. The unclaimed checks should then be turned over to a custodian so the internal audit function does not assume operating responsibilities. Ordinarily, the auditor examines the endorsements on payroll checks while obtaining an understanding of and testing the payroll cycle, which includes consideration of clock cards. The voucher system does not pertain to payroll. This is a possibility, but (a) is better. As part of the cash audit, the auditor would normally only examine checks returned with the cut-off bank statement. Test of accruals would not involve examination of canceled paychecks. In considering whether transactions actually occurred, the auditor is most concerned about the proper separation of duties between the personnel department (authorization) and the payroll department (processing the transactions). This relates to completeness. This relates to accuracy. This would not provide evidence about occurrence of payroll transactions.

8C.15

8C.16

8C.17

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Accounting is a recordkeeping function and may prepare a voucher for execution in other departments Accounts payable is a recordkeeping function and may prepare checks as long as they are not the signer (authorization function) The payroll department assembles payroll information, which is a recording function. Custody of assets, such as unclaimed payroll checks, is incompatible with record keeping. Personnel is authorization function and it is within this function to authorize terminations and provide proper documentation to the appropriate departments. Clock in and out indicates the time spent at the facility and includes breaks, lunch and other time that is spent when not working. Recalculating time cards provides evidence that hours were totaled correctly. This does not indicate that these hours were only for work performed. Signing the time cards would not provide evidence that the employee performed work for the hours listed on the time card. The employee‘s direct supervisor is in the best position to know if the employee worked the hours indicated on the time card. The supervisor‘s approval is the best evidence that the hours on the time card were for hours worked. Supervisors are an authorizer for time worked. Giving the supervisor the pay checks for distributions violates the separation of duties because the supervisor has custody of the asset. Setting the pay rate for the department would not prevent fraud. In fact, the supervisor might take a kick back for authorizing a higher rate creating another possibility of fraud. The ability of a supervisor to authorize the hiring and firing of employees provides an opportunity for ghost payroll. A summary of hours worked would not provide any additional opportunities for fraud and may detect a payroll fraud if some employees were working a significant number of hours above other employees in the same areas.

SOLUTIONS FOR EXERCISES AND PROBLEMS 8C.18

Major Risks in Payroll Cycle Payroll Cycle Risk

Assertion

Paying fictitious ―employees‖

Occurrence, employees exist

Overpaying for time or production Accuracy of payroll amounts, proper inventory, cost of goods sold, and expense amounts Incorrect accounting for costs and expenses

Accuracy, classification

8C.19

Payroll Authorization in a Computer System Because authorization is an important control activity, the point(s) of authorization should be determined. Authorization of payroll transactions cannot be determined without understanding the complete flow of transaction processing (manual and computer). The following could be points in the flow where authorization takes place:       

8C.20

When the computer application program is written (and approved) to accept certain employee codes and to compute the gross payroll and the net amount. When the foreperson initials the time card. (Alternatively, the time may be automatically entered from a time clock into the computer files without foreperson‘s initials—then the employee clocking in and out is the authorization.) When payroll batches of time cards are totaled and submitted to data conversion. When the time cards are input. When the payroll programs are run using the time clock transactions and the payroll master file. When the signature plate is installed on the printer and checks are printed. When the pay rate is entered into the employee master file.

Payroll Processed by a Service Organization This discussion question brings up the auditors‘ responsibility when payroll is processed by a service bureau, a common occurrence in many smaller businesses. The main point is that the audit control concerns are the same wherever the data is processed. Following are some of the discussion points that have come up in the past use of this question.      

8C.21

Audit planning will require determination of whether a report person is available from the service bureau. Of particular interest is whether the service auditor‘s report covers ―design only‖ or both ―design and certain tests of controls.‖ When a service bureau is used, client personnel are responsible for user input and output control (e.g., authorization, completeness (batching), reconciliation of input controls to output. Specific contractual agreements of control responsibilities between the client and the service bureau need to be examined and evaluated. General controls are the responsibility of the service bureau (e.g., system and program documentation); backup for computer processing, data files, documentation and staff; and restrictions over access to computer equipment, data files and programs. Service bureau processing requires increased emphasis on client procedures for verifying continuing authority, completeness, and accuracy of master file. Service bureau processing requires increased emphasis on error correction and resubmission procedures.

Payroll Audit Procedures, Computers, and Sampling a.

Audit procedures: Obtain a sample of weekly batches of time cards and recalculate the totals of labor hours and social security numbers. Labor hour data distributed by the cost accounting department may serve as a cross-check. These control totals should then be compared to the payroll register totals for the same period (and to control totals obtained after keyboard entry, if available). Deviation rate: The expected deviation rate should be zero. Although some input errors might occur, they should be detected and corrected using the control totals for labor hours and social security numbers.

Tolerable rate: Because payroll costs probably represent a significantly large cost item in a manufacturing company, the tolerable rate might be quite low, say 2 percent or 3 percent. Sample items: The sample items should be from appropriate populations; in this case, either the batches as described above, the 300 employee files, or each employee‘s weekly payroll (52 x 300 = 15,600 worker/week payments). Sample size factor: Include expected deviation rate, tolerable deviation rate, risk of assessing control risk too low, and the population size (if small). b.

Select personnel files at random and compare the authorized job classification and pay rate to the union contract and to the database (tape or cards) that contains the table used in computer memory. This procedure yields evidence that the internal computer table is accurate. By reviewing documented changes in the table, its contents throughout the period under audit may be reviewed. Extract a sample of names—classifications—rates from the table itself and vouch these to the personnel files to detect errors of commission in the table. To determine whether rates are actually used properly, the auditor may test the computer application with simulated transactions or she or he may audit ―around‖ the calculations by vouching payroll register output to time cards and personnel files, and by retracing samples from time cards and personnel files forward to the payroll register. These procedures differ from a completely manual system only with respect to the need to test the adequacy of the machine-stored rate table and in the test data application. Otherwise, the procedures are equally applicable to a manual system for preparing the payroll.

8C.22

Payroll Tests of Controls Procedure

Evidence

Sample of clock cards: Note supervisors‘ approval. Trace to periodic payroll registers. Sample of payroll register entries: Vouch hours paid to clock cards and supervisors‘ approval.

Missing approval deviation Wrong hours deviation. Wrong employee deviation.

Recalculate gross pay, deductions, net pay.

Wrong hours deviation. Missing approval deviation Inaccurate pay calculation deviation.

Recalculate payroll registers.

Inaccurate payroll summary deviation.

Examine canceled payroll checks and endorsements.

Inaccurate check amount of deviation. Invalid endorsement deviation.

Vouch periodic payroll totals to payroll bank account transfer vouchers and deposit.

Inaccurate payroll transfer deviation. Missing payroll transfer deviation.

Trace payroll entries to year-to-date records.

Incomplete update deviations.

Reconcile year-to-date records with total payrolls.

Inaccurate payroll (tax return) deviation.

Trace payroll to management reports and to general ledger.

Accounting incomplete deviation. Accounting incomplete deviation.

CHAPTER 09 Production Cycle LEARNING OBJECTIVES Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1. Describe the production cycle, including typical source documents.

1, 2, 3, 4,

25, 26, 27

2. Identify significant accounts and relevant assertions related to the production cycle.

5, 6, 7

29, 40

3. Discuss the risk of material misstatement in the production cycle.

8, 9

32, 49

10, 11, 12

28, 30, 34

51, 53, 67(*)

13, 14

41, 42, 45, 50

15, 16, 17, 18, 19, 20, 21, 22, 23, 24

31, 33, 35, 36, 37, 38, 39, 43, 44, 46, 47, 48

54, 55, 56, 57, 58, 59, 60, 61, 62, 67(*), 68

4. Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion in the production cycle. 5. Give examples of tests of controls to test the operating effectiveness of internal controls in the production cycle. 6. Give examples of substantive procedures in the production cycle and relate them to assertions about significant account balances at the end of the period. 7. Apply your knowledge to perform audit procedures in the production cycle and evaluate the findings of your tests.

67(*)

63, 64, 65, 66, 69, 70, 71, 72, 73

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 9.1

Production planning Production Cost accounting

9.2

GAAP recognizes specific identification, weighted average, FIFO, and LIFO methods of accounting for inventory.

9.3

The auditor performs a walkthrough by talking to employees about their duties, observing performance, and examining documents produced and agreeing them to related documents. A walkthrough of a production transaction will collect the following documents:          

Production order. Bill of materials. Materials requisitions. Inventory record (raw materials issue). Journal entry (moving raw materials to work in process). Labor report (time records). Journal entry (charging labor to work in process). Production cost analysis. Inventory record (finished goods addition). Journal entry (moving work in process to inventory).

Documents should be agreed to production orders based on the bill of materials. The requisitions should also agree to the inventory record, which is agreed to the journal entry. The labor report would be agreed to time records and the journal entry. The journal entries would be summarized and agreed to the production cost. The finished goods addition would be agreed to the production cost and the journal entry. Controls: The auditor would look for the following:     a. b. c. d.

Approval signatures on requisitions, and time records. Approvals of journal entries. Tests of accuracy of calculations. Separation of Custody of the inventory. Record keeping. Authorization of use of materials and incurring time. Reconciliation of inventory records to physical counts.

9.4

Some work to obtain assurance about the reasonableness of the client‘s sales forecast needs to be performed. The auditors need to learn about the assumptions built into the forecast for the purpose of ascertaining their reasonableness. The auditor may gain an understanding as to how production is determined and the flow of product through the warehouse to the customer. In addition, some work on the mechanical accuracy of the forecast should be performed to avoid embarrassing reliance on faulty calculations. If sales forecasts appear to be flawed or inaccurate, finished goods may be produced that may not sell in a timely manner. This finished goods inventory may result in slow moving or overvalued inventory.

9.5

Companies produce good in accordance with the sales forecast. If actual sales do not meet sales forecasts, all the finished goods produced will not sell and will remain in finished goods inventory. The auditor must determine if these goods will sell in the future and if so at what price. If substantial finished goods remain in inventory and there is a question of the salability of the goods, the auditor may require the client to write down the value of finished goods inventory.

9.6

   

Management asserts that inventory exists (existence), the company owns this inventory (rights), the inventory is properly valued (valuation), all inventory is included this amount (completeness), 1-226 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

  9.7

9.8

the valuation method for inventory is disclosed (presentation and disclosure), only inventory is included in this amount (presentation and disclosure). The cost accounting department uses director labor, direct materials and an application of overhead costs to determine product costs. Risks included in this process include inaccurate reporting of labor hours or labor rates, an overstatement of materials used, inaccurate scrap rates (scrap materials are usually charged to the production run), and an inappropriate overhead rate.

   

The recording of the valuation is difficult for many reasons: it is often difficult to get an accurate count of inventory. Although amount is typically a valuation issue and count is an existence/completeness issue, a bad count does affect the amount. because often inventory is purchased at many different times at many different values inventory valuation assumptions are necessary (e.g. LIFO) all inventory items may not be usable and therefore have no value. For example, if a company has an inventory of 200,000 bottle caps, some (say 400) may be defective and not useable. Slow moving or obsolete inventory may be difficult to detect and value.

9.9

Inventory errors are pervasive because the ending inventory number appears on the balance sheet and is also used to calculate cost of goods sold. In turn, cost of goods sold is used to calculate profit and income numbers, which influences retained earnings and equity. Therefore errors in inventory affect multiple items on the financial statements.

9.10

Failure to record materials used should be prevented by matching pre-numbered and sequential documents. Further, a comparison of specifically identifiable items can help. For example, dated raw materials inventory issues not matched to materials in the production cost analysis indicate a possible omission of material used in production. Use of prenumbered documents and reports to account for a numerical sequence is also a primary means of preventing omission of transactions.

9.11

Auditors are looking for the separation of duties in authorization of transactions, custody of assets, recording of transactions, and periodic reconciliation. In the production cycle, these duties are separated as follows: a)

Initial authorization is a production order prepared in production planning and control; authorizations of labor hours and material to be used are given by the supervisor when job time tickets are given to employees and material requisitions are sent to raw materials stores.

b) Cost accounting clerks analyze independent recording of labor and materials in production cost from records after comparing two sources. c)

Raw materials stores maintain physical custody of raw materials, none of which are released without authorization (requisition) and record of withdrawal. The supervisor maintains custody of work-in-process inventory.

9.12

The production order record provides a control over the quantity of product manufactured by the production department. Used in combination with the bill of materials, this record provides an approved list of materials that should be used. This list can be compared to the actual materials used as recorded by the cost accounting department.

9.13

This is a question about the direction of tests of controls. a.

To determine whether all authorized production was completed and placed in inventory or written off as scrap, the auditors should select a sample of approved production orders from the production

planning department files and then trace them forward through cost accounting to inventory or write-offs. b.

9.14

To determine whether finished goods inventory was actually produced and costs were properly accumulated, the auditors should select a sample of production put in the Inventory account and then vouch these production reports to approved production orders and cost calculations of material, labor, and overhead.

Any document is prenumbered in order to account for the items and ensure that no document is missing. A missing receiving report would allow physical items to be entered into inventory without being entered into the inventory records. Such an inaccurate inventory record may result in unnecessary purchases by the company. In addition, if goods were received that had ―street‖ value (e.g. computers) these items could be stolen and the receiving report destroyed. A Prenumbering of the receiving reports would allow management to determine that goods were unaccounted. The auditor could trace receiving reports to the inventory records to determine that these items were properly recorded in the inventory records (completeness and accuracy). The auditor could trace the receiving report to the actual items received (e.g. equipment, parts, etc.) (existence). The auditor could vouch the receiving reports to the purchase orders to ensure these goods were actual ordered by the client (occurrence and rights).

9.15

9.16

The auditor considers these characteristics in a review of the client‘s inventory-taking instructions: a.

Names of client personnel responsible for the count.

Dates and times of inventory taking.

Names of client personnel who will participate in the inventory taking.

Instructions for recording accurate descriptions of inventory items, for count and double-count, and for measuring or translating physical quantities (such as counting by measures of gallons, barrels, feet, dozens).

Instructions for making notes of obsolete or worn items.

Instructions for the use of tags, punched cards, count sheets, computers, or other media devices and for their collection and control (a typical inventory count sheet is illustrated at Exhibit 9.7).

Plans for shutting down plant operations or for taking inventory after store closing hours and plans for having goods in proper places (such as on store shelves instead of on the floor or of raw materials in a warehouse rather than in transit to a job).

Plans for counting or controlling movement of goods in receiving and shipping areas if those operations are not shut down during the count.

Instructions for computer compilation of the count media (such as tags, count sheets) into final inventory listings or summaries.

Instructions for review and approval of the inventory count; notations of obsolescence or other matters by supervisory personnel.

Instructions for making changes and corrections to count tickets.

Dual-direction sampling in the context of inventory test counts proceeds as follows: 1-228 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

In one direction, a sample of inventory items can be chosen from the perpetual records or inventory count tags for test count to ascertain that recorded inventory was counted (existence).

In the other direction, the auditor can count a sample of items in their locations, record them, and later trace them to the perpetual records and inventory summary count sheets to ascertain whether all inventory in place was recorded and counted (completeness).

9.17

Amounts on inventory count sheets and tickets become the amounts in the inventory, so a fictitious item on the count sheet or ticket becomes a fictitious item in inventory. If the auditors do not obtain control information, the client can easily add amounts to the inventory count without the auditors‘ knowledge.

9.18

The auditor should document:  Whether the client‘s personnel were following the inventory instructions.  Test counts taken, including description, and quantity.  The ticket or count sheet numbers that were used as well as the numbers of voided and unused tickets.  The last receiving reports and shipping documents used and the number of the next unused item.  The condition of the inventory.  Any inventory on hand that is not owned by the client.  Any unusual items noticed during the count.

9.19

The auditor must obtain shipping and receiving cutoff information during the physical inventory observation to ensure that items recorded as receipts or shipments in the accounting records match purchases included and sales excluded from inventory in the perpetual records. The perpetual records are compared to the count to determine the book to physical inventory adjustment.

9.20

In this type of situation, the auditor will arrange to be present during one more of the test counts, and importantly, he or she will evaluate the cycle or statistical plan for validity. During his or her observation of the inventory taking, the auditor will employ the usual inventory audit procedures, perform test counts and be responsible for a conclusion concerning the reasonable accuracy of perpetual quantity records.

9.21

The client‘s managers may be making record of the auditors‘ test counts so they can fraudulently change the counts on items the auditors did not count.

9.22

Obsolete or slow-moving inventory is often indicated by:  Inventory turnover ratios.  Trend analysis of inventory levels.  Days sales in inventory ratio.  Sales trend analysis. Note: All of these procedures are more powerful as you disaggregate the data.

9.23

When a client has multiple locations, the auditor should observe the cycle counts on a surprise basis. Depending on the assessed level of control risk, the auditor may observe more or fewer counts, and the timing of the counts may vary. If the client has perpetual inventory records and control risk is low, the auditor may rely on roll-forward testing from the dates of the counts.

9.24

An inventory roll-forward is when the quantity of inventory is counted at a date prior to the financial statement date and then carried forward using documentation purchases and sales between the count date and the financial statement date. The auditor should test whether purchases and sales were properly included in the inventory balance subsequent to the count date.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 9.25

9.26

9.27

9.28

9.29

9.30

9.31

Incorrect

Correct

Incorrect

b. c. d.

Incorrect Correct Incorrect

Incorrect

Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

c. d.

Correct Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b. c.

Incorrect Incorrect Incorrect

Raw materials and supplies purchased are linked through the acquisition and expenditure cycle. Labor and costs are linked through the payroll cycle. Cost of goods sold and reduction to finished goods inventory is linked through the revenue and collection cycle. The finance and investment cycle is not directly linked to the production cycle, although it is indirectly linked through investments in property, plant, and equipment. This is what the company plans to sell, not produce. Some of the planned sales may come from existing inventory, and some of the production may be sold in future periods. These reports indicate what was actually produced. The production plan shows what is planned to be actually produced. The purchases journal shows what was actually purchased during the period.

The job cost sheet indicates the costs used in production and would provide weak evidence as to the occurrence of any transactions or events The job cost sheet indicates the costs used in production and would provide no evidence that production or any related accounts were complete. The job cost sheets indicate the cost used in determining the accuracy of inventory produced. The job cost sheet indicates the costs used in production and would provide no evidence regarding the proper classification of transactions This is a common practice that enhances efficiency. See answer (a). This weakness is an improper combination of inventory custody and recordkeeping responsibilities. See answer (a). The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level. The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level. This is the most disaggregated level of the choices given. The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level. This might detect the theft but wouldn‘t prevent it. This wouldn‘t necessarily detect the theft. The separate space facilitates security, and the frequent counts enable company personnel to detect shortages in a timely manner. This would account for legitimately moved inventory, but those people stealing inventory would not file proper forms. This step would not provide evidence of whether the items are owned. This step would not detect obsolescence. Ensuring physical presence would require tracing from the listing to inventory tickets.

9.32

9.33

9.34

9.35

9.36

9.37

Correct

If the sample is from the inventory in the physical location, the tracing has the objective of auditing the completeness of the final inventory schedule.

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

This would make the count lower than the perpetual records. Unrecorded credit memos means that the returned inventory is not in the perpetual records; thus, the recorded amount will be smaller than the amount on hand. This would make the perpetual records higher than the physical count This would make both the physical count and perpetual records too low.

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Incorrect

b. c.

Incorrect Correct

Incorrect

Correct

b. c.

Incorrect Incorrect

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Controls must be strong for the roll-forward to be reliable. Auditors rely on accurate perpetual records to maintain an accurate inventory balance during the intervening period between the physical count and the balance sheet date. Slow-moving inventory is easier to roll-forward. This has nothing to do with when the count should be taken. This step helps ensure existence as well as completeness; however answer (c) is better. This ensures that goods will not be stolen (existence assertion). Checking the numbering sequence on prenumbered receiving reports is a way to detect omission of the recording of inventory received. These are not incompatible duties that must be separated. An auditor does not expect all inventories to which the auditee has title to be on hand at the date of the count. Some purchased goods may still be in transit at that time. Also, some inventory may be on consignment or in public warehouses although properly included in the count. An auditor does review inventory pricing to ensure cost data are accurate. An audit of inventory would include procedures to ensure that inventory is properly presented and all required information is disclosed. A review of the physical inventory includes the observation of inventory for obsolete and slow moving items This may be done, but the persuasiveness is low because of the weak controls. No! Controls are tested when they are strong and can be relied on. If control risk is high, a timelier audit procedure may be necessary, and extending the results of work done on an interim basis to year-end might be inappropriate. Thus, observation of inventory at year-end would provide the best evidence as to existence. This can be done only if controls can be relied on. This procedure does not provide evidence about rights and obligations. Tracing the details of test counts to the final inventory schedule assures the auditor that items in the observed physical inventory are included in the inventory records. The auditor should compare the inventory tag sequence numbers in the final inventory schedule to those in the records of his or her test counts made during the client‘s physical inventory. The auditor would go in the opposite direction to test existence and occurrence. This pertains to the presentation and disclosure assertion.

9.38

Incorrect

Correct

c. d.

Incorrect Incorrect

9.39

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Turnover has little to do with the existence assertion. Turnover has nothing to do with rights and obligations. See answer (b). Assertions about valuation or allocation concern whether asset, liability, revenue, and expense components have been included in the financial statements at appropriate amounts. An examination of inventory turnover pertains to the audit objective of identifying slow-moving, excess, defective, and obsolete items included in inventories. This audit objective relates to the valuation or allocation assertion.

9.40

a. b. c. d.

Incorrect Incorrect Incorrect Correct

See answer (d). See answer (d). See answer (d). The first inclination is to choose answer (a) because the auditor is vouching, and vouching usually implies a test for existence. However, in this case, a vendor invoice would provide evidence about only the amount that is being billed (valuation) but would not provide information regarding the fact that the goods were received and appropriately included in the inventory status report. Vouching for existence and tracing for completeness are good guidelines, but should not replace the students thought process on what evidence is being gathered

9.41

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Inspecting documents for approvals is a typical test of controls. See answer (d). See answer (d). Policy and procedure manuals are least important because the most important features are the actual workings of the controls as indicated by the other three choices.

9.42

a. b. c.

Incorrect Incorrect Incorrect

Correct

This is the focus of substantive tests. See answer (a). Financial statements but not accounting systems per se should be produced in accordance with GAAP. Auditors need to determine whether the cost accounting system assigns costs properly to the inventories.

a. b. c.

Incorrect Incorrect Incorrect

Correct

9.43

Physical presence does not necessarily imply ownership. The goods may be pledged or on consignment. The major audit objective of testing the assertion of rights and obligations for inventories is to determine that the entity has legal title or similar rights of ownership to the inventories. Typically, the auditor will examine paid vendors‘ invoices, consignment agreements, and contracts. This is a test for cutoff. The wording of the question implies that this is a test for presentation and disclosure. The procedure does, however, reveal obligations for purchase commitments. Answer (b) is better because of the way the question is worded.

Cost ledgers are focused more on cost than on quantities. The perpetual inventory records are not original documents. Receiving reports usually reflect materials going into raw materials, not work-in -process. Material requisitions are the authorization for the inventory custodian to release raw materials and supplies to production personnel.

9.44

9.45

9.46

9.47

9.48

9.49

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Incorrect

b. c. d.

Incorrect Correct Incorrect

Incorrect

Correct

Incorrect

Correct

c. d.

Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

c. d.

Incorrect Incorrect

This tests whether the reductions in inventory for shipments were accurate. This tests whether the additions to raw materials inventory for purchases were accurate. This provides an overall test of the accuracy of the perpetual records. If the controls are excellent and the roll-forward is tested, a recount is not necessary. If controls are weak and control risk is high, the auditor of a nonpublic company would not test the controls. Tests of controls do not test inherent risk. The auditor tests the controls to reduce substantive tests. This is not a requirement of GAAS for nonpublic companies. Determining that the entity has the rights to the inventory does not provide evidence that all inventory items have been recorded in the ending balance. Determining that the inventory is properly valued does not provide evidence that all inventory items have been recorded in the ending balance. Determining that the inventory is properly presented does not provide evidence that all inventory items have been recorded in the ending balance. Completeness by definition is the assertion that all items are reflected in the balance. The inventory may be observed, but to do this the auditor must go to the public warehouse. Depending on the distance this is usually not viewed as an efficient means of gathering evidence. Sending a confirmation to the public warehouse asking for verification of inventory held is an efficient method for gathering evidence of the existence of this inventory. A calculation of the inventory value does not provide evidence of its existence. Inspection is an evidence term usually reserved for the examination of documents and would not provide better evidence of existence than a confirmation. Tracing tags to the inventory listing provides evidence that the items counted and recorded on the tags were recorded in the inventory list. This is the completeness assertion (i.e. the inventory list is complete). To collect evidence of that items on the inventory sheet were counted the auditor would determine if the items of the listing were counted by vouching to the inventory tags. This is the opposite of answer A and provides evidence of existence (items on the list exist), not completeness. Tracing tags to the inventory listing would not provide any information about the valuation (e.g. lower of cost or market). Tracing tags to the inventory listing would not provide any information about the valuation (e.g. items were properly valued). A decline in the current ratio could indicate an unrecorded current asset, such as inventory. A decline in the inventory turnover ratio could be an indicator of an overstatement of inventory, either fictitious quantities or unsaleable/overvalued inventory. An increase in the inventory balance is unlikely to signal an understatement. Although accounts payable is related to inventory purchases, a decline in A/P turnover typically means a potential overstatement of A/P, which would not indicate an understatement of inventory, but could relate to a possible overstatement of inventory.

9.50

Incorrect

Correct

Incorrect

Observation is often a sufficient and appropriate test of the operating effectiveness of a control, and is rated highly in the hierarchy of tests of controls according to auditing standards. Inspection of documents is a common test of the operating effectiveness of controls and may provide sufficient, appropriate evidence related to operating effectiveness for some controls (for example, authorization controls or reconciliation of pre-numbered documents). Inquiry by itself is not sufficient, appropriate evidence of operating effectiveness of a control because the auditor has not obtained evidence that the control is in fact operational. Reperformance of a control is often sufficient and appropriate for reaching conclusions regarding the operating effectiveness of a control.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 9.51

Internal Control Questionnaire Items: Possible Error or Fraud Due to Weakness Question

Possible Error or Irregularity

Fraud or error in production, payroll, or reporting concealed in cost records.

Unauthorized production for personal products.

Materials withdrawn from inventory or hours worked for unauthorized projects.

Materials withdrawn for personal use.

Production may be started for uneconomic jobs or personal projects.

Materials and labor may be used for uneconomic jobs or personal projects.

Errors in material usage or theft by storeroom employees.

Errors in labor costs.

Foreperson incorrectly requests material or assigns job skills.

Not all material or labor accounted for correctly. The foreperson could also conceal unauthorized material or labor in an authorized job.

Production orders lost and accounting incomplete.

Lost forms resulting in labor or material used but not recorded.

Labor or material used but not recorded.

Issue slips not compared to material used reports. Material withdrawn from inventory not accounted for. Lost forms resulting in inventory not charged to Cost of Goods Sold.

Failure to disclose agreements in footnotes.

Inclusion of goods on consignment in inventory accounts.

Scrap reporting incorrect. Incorrect perpetual inventories.

Differences not investigated. Labor used not accounted for by assigning to a job.

Incorrect costs used; inventory improperly valued.

Comparison not made or difference not investigated. Production completed not put into inventory.

Inventory transactions posted in wrong period. Cutoff errors.

Errors in summary entries not detected and corrected.

Accounting entries may get put in the wrong account.

9.52

Tests of Controls Related to Controls and Assertions

Procedure (1)

(a) Strength Preparation of summary material and labor entries.

(b) Assertion Valid work-in-process inventory transactions are recorded and none omitted (completeness).

(2)

Production cost sheets prenumbered and accounted for.

Valid finished goods inventory transactions are recorded and none omitted (completeness).

(3)

Independent check on materials and labor used.

Recorded labor and material transactions are valid (occurrence).

(4)

Issue forms secure and used by authorized personnel. Prenumbered and accounted for.

All material issues are authorized (occurrence). All issue forms are recorded (completeness).

(5)

Use of control account.

Production transactions are recorded properly (classification).

(6a)

Recording of materials used.

Material used is recorded in proper period (accuracy).

(6b)

Standard control number.

Job accounting is complete (completeness).

(6c)

Material received custody.

Material used is authorized (occurrence).

(6d)

Proper material received.

Job cost accounting accurate (accuracy).

(6e)

Proper release of correct materials.

Material release recorded accurately (accuracy).

(6f)

Material release authorized and timely.

Authorized issue of material and in proper period (occurrence, accuracy).

(7)

Timely recording.

Inventory recorded in proper period (completeness, cutoff).

9.53

Cost Accounting Test of Controls

Procedure

Evidence

Sample of Cost Accounting Payroll Analyses Reconcile periodic totals with payroll register record of payments.

Incomplete costing deviation.

Vouch costs to time records.

Invalid time analyzed deviation.

Trace cost accounting labor distributions to management reports and postings in general ledger and subsidiary account(s).

Inaccurate reporting deviation. Incomplete accounting deviation. Wrong classification deviation.

Sample of Recorded Labor Cost Items Vouch labor cost entries and management reports to supporting labor cost analyses.

Invalid entries deviation.

9.54

9.55

Inventory Count Observation: Planning and Substantive Procedures a.

Sammy should find in the audit working papers a planning memo describing the client‘s inventory-taking plan and notes about the auditors‘ firsthand observation of the instructions being given to counters, along with a memo about the auditors‘ observation of the counting. This memo should tell about supervision of the audit staff, and the working papers (test counts) should show the review signatures of the supervising auditors.

Working papers should document performance of these substantive procedures for the existence and completeness assertions: (1)

Conduct an observation of the company‘s physical inventory count.

(2)

Scan the inventory compilation for items added from sources other than the physical inventory count.

(3)

At year-end, obtain the number of the last shipping and receiving documents. Use these to scan the sales, inventory/cost of sales, and accounts payable entries for proper cutoff.

(4)

Confirm or inspect inventories held in public warehouses.

(5)

Select sample of used tags and trace them to the items on the floor.

Sales/Inventory Cutoff In view of the information given, the following adjusting entries would be necessary: For the first item: Inventory Control Inventory Variation (CGS)

28,400 28,400

For the third item: Sales

21,300 Accounts Receivable

Inventory Control Cost of Sales

21,300 18,900 18,900

Because the goods in the first item were shipped prior to the taking of the physical inventory, the Inventory Control account was reduced by the cost of these goods in the adjustment that arose from the physical inventory. Because the client credited Inventory Control for the cost of these goods on December 16, one of these two credits must be removed. The above entry reverses the one made on December 15 with respect to these goods and leaves Cost of Sales properly charged with the $28,400 as a result of the December 16 entry. The sales entry was made properly and requires no adjustment. In the second item, the client has reduced the control account at the shipment date prior to taking the physical inventory. The control was in agreement with the physical count on December 15 so far as these goods were concerned, and the December 15 adjustment did not relate to these goods. Because the accounts involved are in agreement with the facts at both December 15 and December 31, no adjustment is necessary. The third item is a sale recorded too early, and both the revenue and cost recognition need to be revised.

9.56

Purchasing Cutoff a.

Correcting entry under periodic system Inventory (RR#1183, 1184) 29,335.13 Accounts Payable (RR# 1183) Purchases

Correcting entry under perpetual system Inventory (RR#1183, 1184) 29,335.13 Accounts Payable (RR# 1183) Cost of Goods Sold

9.57

11,482.57 17,852.56

Statistical Sampling Used to Estimate Inventory a.

The following procedures are based upon, but not copied from, Appendix 9B: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

Review and be satisfied with the client‘s physical inventory-taking procedures. Observe the physical count. Make test counts where appropriate. Trace selected count data to the inventory compilation. Select items from the compilation and vouch them to original count data. Select items from the warehouse at random and trace these items to the perpetual inventory record. Verify footings. Compare inventory compilation amounts to the subsidiary ledger control accounts and investigate significant differences. Ascertain that there was a proper purchases and sales cutoff. Review the treatment of merchandise in transit and consigned merchandise. Confirm merchandise in public warehouses. Perform an overall analytical review of inventories. Account for all client inventory count sheets. Be sure that inventory items are properly classified, in good condition, and of proper quality.

When a client uses statistical sampling to estimate inventories, the auditor should perform procedures similar to the following: (1)

Review the client‘s procedures and methods for determining inventories to ascertain that they are sufficiently reliable to produce results substantially the same as those that would be obtained by a 100 percent inventory count.

(2)

Be satisfied that the statistical sampling plan to be used by the client has statistical validity and will be properly applied and that planned tolerable misstatement and sampling risk as defined statistically will be reasonable.

(3)

Ascertain that proper steps have been taken to ensure that all parts and supplies in the warehouse are included in the perpetual inventory record. This would normally be checked before the physical count.

(4)

Be present when the sample is drawn to make sure that the requirements for random selection are properly observed and that all items in the inventory have an equal or determinable probability of selection.

9.58

(5)

Be present to observe counts and be satisfied with the client‘s counting procedures. The inventory observation can be made either during or after the year-end of the period under audit if well-kept perpetual records are maintained and the client makes periodic comparisons of physical counts with such records.

(6)

Review the statistical evaluation and be satisfied that the estimated value of the tolerable misstatement at a given level of sampling risk meets the materiality requirements set for the audit.

Inventory Procedures Using Computer-Assisted Audit Techniques (CAATs) Basic Inventory Audit Procedures

How Audit Software and Inventory Data Files Can Help

Observe the physical count, making and recording test counts where applicable.

Determine which items are to be test counted by making a random sample of items from the inventory file as of the date of the physical count.

Test the mathematical accuracy of the inventory compilation (summary).

Mathematically compute the dollar value of each inventory item counted by multiplying the quantity on hand by the cost per unit and verify the addition of the extended dollar values.

Compare the auditors‘ test counts to the inventory records.

Arrange test counts in a format identical to the inventory file and matching the files.

Compare physical count data to inventory records.

Compare the total extended values of all inventory items counted and the extended values of each inventory item counted to the inventory records.

Test the pricing of the inventory by obtaining a list of costs per item from buyers, vendors, or other sources.

Prepare a file of costs and match to the inventory file.

Examine purchase and sale cutoff.

List a sample of items on the inventory file for which the date of last purchase and date of the last sale are on or immediately prior to the date of the physical count.

Ascertain the propriety of items of inventory located in public warehouses.

List items located in public warehouses.

Analyze inventory for evidence of possible obsolescence.

List items on the inventory file for which the date of the last sale indicted a lack of recent transactions.

Analyze inventory for evidence of overstocking or slow-moving items.

List items for which the quantity on hand is excessive in relation to the quantity sold during the year.

j..

Perform overall test for accuracy of inventory master file.

List items, if any, with negative quantities or costs.

9.59

CAATs Application: Inventory a.

The purpose of a computer audit software package is to provide computer programs that can process a variety of file media and record formats to perform a number of functions. A package can be used to perform or verify mathematical calculations; to include, exclude, or summarize items having specified characteristics to provide subtotals and final totals; to compute, select, and evaluate statistical samples for audit tests; to print results in a form specified by the auditor; to arrange detailed items in a format or sequence that will facilitate an audit step; to compare, merge, or match the contents of two or more files; and to produce machine-readable files in a format specified by the auditor.

Ways in which a general-purpose computer audit software package can be used to assist in the audit of inventory of Boos & Becker, Inc., include the following: (1)

Compare data on the inventory count sheets to data on the computer inventory master file and list all differences. This will ensure that the set of count cards furnished to the CPA is complete.

(2)

Determine which items and parts are to be test counted by making a random selection of a sample from the audit deck of count cards or the disk inventory master file. Exclude from the population items with a high unit cost or total value that have already been selected for test counting.

(3)

Read the client‘s disk inventory master file and list all items or parts for which the date of last sale or usage indicates a lack of recent transactions. This list provides basic data for determining possible obsolescence.

(4)

Read the client‘s disk inventory master file and list all items or parts of which the quantity on hand seems excessive in relation to quantity used or sold during the year. This list provides basic data for determining overstocked or slow-moving items or parts.

(5)

Read the client‘s disk inventory master file and list all items or parts of which the quantity on hand seems excessive in relation to economic order quantity. This list should be reviewed for possible slow-moving or obsolete items.

(6)

Enter the audit test count quantities into the computer. Match these counts against the client‘s adjusted disk inventory file comparing the quantities on the cards to the quantities on the disk file and list any differences. This will indicate whether the client‘s year-end inventory counts and the master file are substantially in agreement.

(7)

Use the adjusted disk inventory master file and independently extend and total the year-end inventory and print the grand total on an output report. When compared to the balance determined by the client, this will verify the calculations performed by the client.

(8)

Use the client‘s disk inventory master file and list all items with a significant cost per unit. The list should show cost per unit and both major and secondary vendor codes. This list can be used to verify the cost per unit.

(9)

Use the costs per unit on the client‘s disk inventory master file and extend and total the dollar value of the counts on the audit test count cards. When compared to the total dollar value of the inventory, this will permit evaluation of audit coverage.

9.60

Inventory Evidence and Long-Term Purchase Contracts a.

Gathering evidence about the contract would involve reading it, discussing the terms with management, asking if any attempt would be made to renegotiate the price, and confirming the terms of the contract with All Purpose‘s.

Facts cited that the auditor would have to discover consist of the current market price information and the informed expectations about the duration of the price level. A general awareness of economic conditions, newspaper reports, aluminum industry trade sources, and consultation with metals commodity experts are sources and means of confirming these ―facts.‖

By all indications, there should be a write-down of inventory to market and a current recognition of loss on the firm purchase commitment. Current inventory write-down: Inventory per books Inventory at market 400 tons@ $.20/lb Write-down to market Loss on purchase contracts: Contract purchases 500 tons 700 tons 1,000 tons 2,200 tons @ $400/ton market Loss on purchase contract

9.61

$ 240,000 160,000 $ 80,000

$300,000 420,000 500,000

$1,220,000 880,000 $ 340,000

Tracing the Inventory Count a.

Inventory plan steps for tracing inventory count information. (1)

Obtain client‘s listing of final inventory count. (a) (b) (c)

Use CAATs to foot listing and check for numeric sequence of inventory tags. Agree total to final inventory in general ledger. Agree test counts obtained during the count to the listing for quantity and description.

(2) Follow up on any unusual items noted during the count. b.

Possible causes of items noted. (1)

It may be that the client did discover additional items. However, the client may be attempting to fraudulently inflate inventory.

(2)

These may be honest errors, or, again, this may indicate possible fraud.

(3)

These items are clearly obsolete. Even if the goods aren‘t broken, they aren‘t being sold.

Follow-up procedures 1.

Request to see the items and the documentation of when they were received. Inquire of count personnel about why they were missed and how they were found.

9.62

Select a large sample of additional tickets and agree them to the listing. Consider having client re-input all the tickets. Determine whether there is a pattern to the errors (all inventory increasing, all in one area, all by one employee).

Determine client‘s plans for selling. Include these items in the lower of cost or market testing, incorporating any planned discounts or other costs of disposing. Ask about any other slow-moving items.

FIFO Inventory Pricing a.

The cost of the jump suits should be: 600 @ $782= 663 @ $777=

$469,200 $515,151 $984,351

The adjusting entry should be: Cost of Goods Sold Inventory b.

3,315

Yes, market value is replacement cost. Thus, the replacement cost is $750. Assuming this is between the net realizable value (ceiling) and the net realizable value less a normal margin (floor), the jumpsuits should be valued at (1263 @ $750) $947,250. The adjusting entry should be: Cost of Goods Sold Inventory

9.63

3,315

40,416 40,416.

Toying around with the Numbers

Audit Approach Objective: 1) Obtain evidence relevant to the accuracy of the inventory including inventory obsolescence. 2) Obtain evidence of proper classification of tooling costs and the amortization of such costs. Control: The sales forecast should be based on realistic assumptions and expectations. The company should have documentation or plausible explanations for the assumptions underlying the forecast. Detail records of tooling cost balances by toy line should carry forward from the end of the prior year to the beginning of the current year in the same amount and for the same toy lines just like the cost of fixed assets. Tests of controls: Nothing about reviewing a sales forecast for reasonableness is routine. The company‘s documentation, if any, should be studied. Persons responsible for its preparation should be interviewed. One typical procedure is to track the record of management‘s past sales forecasts with subsequent actual sales experience. Responses to inquiries should be analyzed for reasonableness on whatever bases are available (excluding wild optimism). Audit of balances: Much of the balance-audit work on inventory obsolescence flows directly from the control testing. In this case, the reliability of the forecast was the crucial step because inventory was not even flagged for the LCM calculation unless it exceeded the forecast. (Not much could be determined from the physical observation because toys don‘t show signs of mold or rust. When oversupplied, they are sold at close-out prices. However, a few parts and raw materials might be ―observed‖ as questionably obsolete.) Review the forecast for curious discrepancies. In this case, zero differences between inventory quantity on hand and forecast sales of toys and usage of parts should bring suspicion that the forecast was ―plugged.‖ Further inquiry into the forecast process is warranted. 1-242 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Beginning balances of unamortized tooling costs should be traced to prior-year working papers or the client‘s prior-year records. This should have showed the movement of prior-year amounts to different toy lines. Amortization rates should be tested against the forecasts, and the forecast experience should be reviewed. Discovery Summary (Adapted; ASR 292) Find obsolete or unsalable inventory, determine inventory valuation, and identify appropriate classification of costs. Inventory and deferred cost overstatement: The auditors did not notice anything curious about inventory quantities and forecast quantities being equal in 19 of 128 lines sampled for detailed audit. They did not notice the interchangeable part numbers‘ reference to the part itself instead of to a new toy. In one of the years, they did not compare prior forecast to subsequent actual sales experience; in the other year, the auditors made the comparison but accepted management‘s explanation of how sales would increase. The auditors apparently did not trace the beginning tooling balances to prior year-end balances and failed to notice the movement of the amounts to other toy lines. However, they did notice the poor forecast experience for tooling amortization and recommended an additional $2 million amortization of the prepaid expense. After discussion with management, an adjustment to amortize another $1.4 million tooling cost was recorded. That still left the balance overstated because the auditors recommended an adjustment only for the sample of items they tested but did not project the misstatement to the entire deferred cost population. 9.64

No Defense for These Charges Audit Approach Objective: Obtain evidence of the reliability of labor costs deferred as tooling and the amount claimed as cost overrun reimbursement on defense contracts. Obtain evidence of the ―existence‖ of the labor cost reimbursement claim in terms of its being supported by sufficient documentation to justify carrying as an asset. Control: The major control lies in the procedures for documenting the reliability of labor cost assignments identifying the time and cost specifically to the categories claimed. For the reimbursement claim, the circumstances also need to meet the terms of the contract respecting cost overrun reimbursement.

Tests of controls: The test of control activity is to select a sample of journal entries that created the assets deferred tooling cost and cost reimbursement claim. Vouch them to supporting documentation. The transactions can be audited for control over occurrence and accuracy. However, these procedures will also satisfy the dual purpose of auditing the asset balances that arise directly from the transactions. Audit of balances: The account balances created by the deferral journal entries are audited (―dual-purpose procedure‖) by auditing the supporting documentation. These balances were created entirely by the journal entries and their ―existence‖ as legitimate assets (cost deferral and reimbursement claim) depends on the believability of the supporting explanations. In connection with the defense contract claim, auditors can review it with knowledge of the contract and the extent of documentation required by government contract auditors.

Discovery Summary By performing the procedures outlined in the Audit Approach section, the manager, audit senior, and staff accountants on the engagement discovered all the questionable and improper accounting. Inventory and deferred cost overstatement: They noticed that the tooling cost deferral labor cost was ―supported‖ by work orders of recent date and numerical sequence, but the labor charge tickets were created several months before. This finding tipped them off that the later journal entry establishing the deferred charge was invented for income manipulation purposes later in the fiscal year. The government contract cost overrun claim had similar deficient documentation. The labor cost had no associated work orders connected with the government contracts in progress. Collectability was very doubtful. The account was adjusted to ―write off‖ the claim. 9.65 Chips Ahoy Audit Approach Objective: Obtain evidence of the reliability about the value of inventory and the movement of inventory shipments. Obtain evidence concerning the value of specific computer chips in the marketplace to determine the lower of cost or market in inventory valuation. Control: The major control lies in the procedures for documenting the value of inventory including the ability to sell inventory and the determination of the market value of computer chips manufactured by ECI. What are the inventory value principles in use (e.g., LIFO) and what are the controls over the inventory calculation (e.g., competence of personnel, review of calculations). Review proper documentation for receiving and removing inventory.

Tests of controls: Review documentation for receiving inventory and review controls over inventory from receiving to receipt in inventory, Review documentation for the sale of inventory and review controls over inventory from removal from inventory to shipping, Review all inventory documents for proper approval. Review duties of inventory personnel and ensure adequate separation of duties.

Audit of balances: Perform analytical procedures on inventory including inventory turnover and days sales in inventory. Review sales reports for slow-moving items or unusual sales patterns such as few but very large sales. The test of control activity is to select a sample inventory items and vouch to vendor invoices for pricing. Vouch inventory to vendor invoice to verify purchase amounts and review market information on current purchase price for inventory. Review current sales orders for sales value and for sales.

The physical inventory should be observed with the auditor:  Inspect the inventory looking for slow-moving or obsolete items.  Inspect inventory counting to ensure that all items are included in the account balances.  Inquire of personnel regarding the salability of inventory items.  Test count selected inventory items.  Vouch items from the count sheet to the actual inventory item. In addition, the auditor should trace sales to payments made on accounts receivable (the real measure of the value of inventory is what someone will pay you for it).

Discovery Summary Inventory and deferred cost overstatement: By performing the procedures outlined in the Audit Approach section, the auditor may notice inventory gathering dust (indicating slow-moving items); test counts that are inaccurate or whether items on the count sheet do not exist. In addition, a review of payments on accounts receivable may indicate fictitious sales. Fictitious sales may involve no inventory or obsolete or unsalable merchandise. 9.66

Detecting Errors and Fraud

Effect on Financial Statements

9.67

Auditing Procedures That Might Have Detected the Misstatement

Total assets overstated; net income overstated.

As part of the roll-forward procedure, auditors would examine the entries to reduce inventory for the cost of sales.

Total assets overstated; net income overstated.

Locations should be visited for an inventory count on a surprise basis.

Total assets overstated; net income overstated.

Examination of purchase records should reveal that the automobiles were not purchased. Inquiry of the client about consignments should also alert auditors to the presence of consigned goods.

Total assets overstated; net income overstated.

Examination of purchase invoices should indicate that the pricing is by thousand feet. Also, comparison to prior periods should show the large increase in the value of wiring.

Total assets overstated; net income overstated.

During the observation of the physical inventory, auditors should request that some boxes be opened. Also, purchase records should indicate that each box has only six baseballs.

Inventory Fraud and Detection Issues i. The inventory assertion violated is existence. Because the company is paying (and therefore recording) a fictitious purchase. The recording of the fictitious purchase results in the overstatement of the quantity of inventory, which is a violation of the existence assertion. ii.The client should require a three-way match of an approved purchase order, a receiving report, and the vendor invoice. Without an approved purchase order, the purchase could not be recorded. iii. The auditor most likely would detect the problem through an inventory count, if the amount is material. It is possible that if this is not a material misstatement, the overstatement of inventory would be treated as normal shrinkage and not noticed. This is why the adoption of a solid system of internal controls is so important. Without appropriate authorization controls on purchases, the opportunity for fraud that may be difficult to detect increases significantly.

9.68

Substantive Testing of Inventory Variances Test Count # 1 2

Appropriate Auditor Response E – This is correctly accounted for – is should not be recorded as a sale yet. G – This is an error – the purchase should not be recorded until received when

3 4 5

purchases are made F.O.B. destination. F – This sale is improperly recorded. The requirements for revenue recognition are not met when the goods have not been legally transferred to the customer. F – This is an understatement of inventory and accounts payable. Goods should be recorded upon receipt by the client. E – This is correctly not recorded as a sale since the inventory has not been transferred to the customer yet.

For 9.69-9.73 Setting Up Data in IDEA 1. Create a managed project in IDEA

2. Obtain the Sales 2020 – 4th Q, Purchases 2020 – 4th Q, Inventory Count, Ending Inventory Balances 2020 -3rd Q, finished Goods Production 2020 -4th Q, Production Bill of Raw Materials, and the Combined Materials and supplies Vendor Price List data sets from Connect. Copy the required data into the project file within documents->My IDEA Projects-> Project name (Chapter 9 IDEA Exercises in this example).

3. Refresh the file list in IDEA to show the databases within your project:

9.69 a.-d. Please see the IDEA Workbook pages 193-218 for detailed solutions. e. Total inventory cost is approximately $626,000. A reasonable estimate of a provision is $150,000. This is a material difference based on any quantitative or qualitative measure of materiality and would require adjustment.

9.70

Summarizing Direct Materials Production Costs Using IDEA ELM reports that the following is the total cost for each product: Product Direct material Direct Labor Overhead* SP001 $ 5.91 $ 1.99 $ 0.16 HB005 $ 13.40 $ 4.96 $ 0.40 CB008 $ 56.39 $ 8.11 $ 0.65

Total Cost $ 8.06 $ 18.76 $ 65.15

* Overhead is allocated at 8% of direct labor costs (rounded) Required: Assume that the cost of Direct Labor and Overhead has been separately verified. Use the Bill of Materials and the Materials Unit Cost sheet to recalculate the Direct Materials cost per unit for the three products. Do you find any differences in calculated materials costs? Solution: For this exercise, you will need the Production Bill of Raw Materials database and the Combined Materials and Supplies Price List database. To calculate the direct materials cost, you will need to summarize the total costs by product, which will require joining the two databases, multiplying out the costs, and summarizing them. First, join the Production Bill of Materials (primary) with the Combined Materials and Supplies Price list (secondary) by PARTNO, retaining all items in the primary database.

It is a good idea to always verify that the Units of measurement are equal for the items – here, they will match up, but that may not always be the case in practice:

Next, append a new column calculating the cost of the required units. Note that this is data->append NOT analysis->append.

Finally, summarize the TOTCOST just calculated by PRODNO to get the total direct materials cost for each product.

The resulting calculated costs are as follows:

A comparison to the costs provided by the client indicate that the direct material costs are accurate, presuming the underlying quantities and prices are accurate – which would be tested separately. 9.71

Summarizing Finished Goods Quantities Using IDEA You have been assigned the task of recalculating the client‘s Finished Goods ending inventory quantity based on sales and manufacturing records and comparing it to the year-end inventory count. You may assume there is no Work-in-Process inventory as of year-end. Required a. Perform an inventory roll-forward and calculate the total year end quantity for each of the three items in Finished Goods inventory (Hints: Beginning Balance + Finished Goods Manufactured – Sales = Ending Balance. Don‘t forget that you should only consider sales that have shipped during the quarter and that the company sells products in cases of 12. You may assume there were no shipments of outstanding orders from prior quarters.). 1.

Get shipped items for 4th Q from the Sales 2020 – 4th Quarter Database (analysis->direct extraction-> SHIPDATE >= "20200101" .AND. SHIPDATE < "20200401” 1-250 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Summarize Production, and Shipped Goods 4th Q (AMT) by PRODNO (Analysis>Summarization) and Inventory Count by PARTNO. Finished Good Production Summarization:

Shipped Goods Summarization:

Inventory Count Summarization:

3. Multiply AMT_SUM by 12 in sales summarization since goods are sold in cases of 12. Use data>append (AMT_SUM*12).

4. JOIN the summarizations. Join Ending Inventory Balances 2020 -4th Q With Finished Goods Production Summary to create FGAFS:

Join FGAFS with Sales Summarization on PRODNO to create FG AFS and Sales:

Join FG AFS and SALES with Inventory Count Summarization using PRODNO for FG AFS and PARTNO for Inventory Count Summarization to create Finished Goods Inventory Reconciliation:

5. Calculate FG Inventory in Finished Goods Inventory Reconciliation as Quantity + PRODQUAN_SUM – FG_SALES_4thQ using data->append

Solution:

b. Compare the ending inventory balances from part a. to the quantity based on the year-end inventory count. Are there any significant discrepancies between the calculated ending inventory and the inventory counts? Recall that performance materiality is $25,000 and total production costs range from ~$8/unit for SP001 to ~$65/unit for CB008. The inventory calculation shows a shortage of 34 units of SP001, 9 units of HB005 and 18 units of CB008. The total cost of the shortages are under $2,000, which is clearly immaterial. Further, relative to the sales volume, the shortages are very small (and not atypical). c. What are some of the reasons that could cause these discrepancies? How would you resolve these issues? There are many reasons why there could be a shortage of inventory. Some of the produced inventory may not have passed inspection, but may not have been properly recorded. The company may have had to send out warranty replacements that were recorded separately. Alternatively, a warehouse employee or other employee could have stolen some of the inventory for personal use or sale, among other explanations. Because the quantity differences are immaterial, the author would most likely move on to price testing of the finished goods inventory and would not spend additional time resolving the differences other than documenting them and discussing with the client. d. What would you propose as the final inventory quantity? 1-255 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Most likely the ending inventory count balances are the most reliable balances. However, without further information about the reliability/timeliness of the ending inventory count, it is not certain that the count is the best number. 9.72 Summarizing Raw Materials Quantities Using IDEA You have been assigned the task of recalculating the client‘s Raw Materials ending inventory quantity based on purchase and manufacturing records and comparing it to the year-end inventory count. You may assume there is no Work-in-Process inventory as of year-end. Required and Solution: a. Calculate the total year end quantity for Raw Materials Inventory (Hint: Beginning Balance + Purchases – Used in Production = Ending Balance. Don‘t forget that you should only include purchases that have been received in calculating purchases. Column ―TYPE‖ in 3rd q inventory database will be helpful for extracting relevant records.) 1. For this exercise you will need Finished Goods Production 2020-4th Q, or use Finished Goods production summary from 9.65. You will also need Inventory Count or use Inventory Count Summarization by Product from 9.65. Further, you will need the Ending Inventory Balances or the Inventory Count Summary from 9.65. 2020 – 3rd Q, Purchases 2020 – 4th Q data set, and the Production Bill of Raw Materials data set. 2. Extract the raw material beginning inventory from Ending Inventory Balances 2020 – 3rd Q (analysis->direct extraction).

3. Extract goods received during the 4th quarter from Purchases 2020 – 4th Q (analysis->direct extract). Use column RECAMT as the quantity received and RECDATE to extract the appropriate goods received.

4. Summarize the Goods Received 4th Q by PARTNO using analysis->summarization.

5. Calculate the Raw Materials used in production. The easiest way to do this is to start with the Production Bill of Raw Materials and join that database with the Finished Goods Production summary (see Step 3 of 9.65 solution if you don‘t have that already), using the Production Bill as the primary database.

6. Using the new Raw Materials Quantity Used – Gross database, use dataappend to multiply the required units/product (PARTREQ) by the production quantity (PRODQUAN_SUM).

Because some raw materials may be used in multiple products, summarize the Raw Materials Used by PARTNO.

8. Join together Raw Materials Beginning Inventory with Goods Received 4th Q Summary (Analysis->Join). Use the Beginning inventory as the primary database since the purchases includes supplies that are not Raw Materials. 1-259 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. Next, join in the Raw Materials Quantity Used by PARTNO (analysis->join).

10. Append a column to RM Beg Purch Used called CALC_RM_INV that will show calculated ending RM inventory (data->append).

11. Next, you will need to create a summarization of the Inventory Count by PARTNO (if 9.71 was done, this was already done in Step 2 of 9.71).

12. Join the RM BEG PURCH USED database with the Inventory Count Summarization by PARTNO and create a database called RM Inventory Reconciliation.

13. Finally, append a column that calculates the difference between the count and the calculated RM Inventory balance.

b. Are there any significant discrepancies between the calculated ending inventory and the inventory counts? Identify possible reasons for such discrepancies. In a manufacturing environment, differences between calculations and counts on raw materials are common because of scrap in the process, imprecisions in the bill of materials, etc. In most accounting systems, clients keep track of raw materials directly with job tickets that track the movement of all items through the process. This helps to minimize differences between the accounting system and counts. For the majority of items in the raw materials listing, the differences between the calculation and the count are immaterial and within what would be expected. However, there are several differences that deserve more discussion: - All three zippers (F0368, F0563, and F1208) have fairly large differences, and the differences go in various directions. There are many possible explanations for this difference, and it is worth discussing with the client, however, the dollar amount is immaterial because the zippers are low cost items (under $1 each). Possible explanations include miscounted inventory since the items are similar and unrecorded purchases (the net difference is a fairly large shortage). Since there is a net shortage, it is also possible that there were items missed during the inventory count. - Similar discussions apply for items M2961, M3785, and M5826 with differences that are in various directions and are likely immaterial. However, they are indicative of potential control problems with raw materials. 1-263 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The one item with a clearly material difference is the S0030 Strap. The calculated quantity of raw materials is -48,523, which is impossible. A small quantity of the item remained in inventory, but there appears to be a material problem with the accounting for this item. There are many possible causes for this, but the two most likely are either significant quantities of unrecorded purchases or an error in the bill of materials with fewer items actually used. The production quantities tested out in exercise 9.71 and other raw materials have reasonable balances, so it is unlikely that finished goods production numbers are the cause of the discrepancy.

c. How would you proceed to resolve these issues? The first step would involve inquiry of the client. It is possible that a very simple explanation exists and there is not actually an error in the accounting records, just an error in the bill of production. However, the auditor will need to obtain sufficient and appropriate evidence to support the explanation given by management. Further, given the number of differences found, the auditor should consider whether controls surrounding raw materials are deficient. d. What would you propose as the final raw materials inventory quantity? Generally, the ending inventory count is the best number for inventory quantity, however, more information is needed to be sure what the ending quantities are. 9.73

Testing Supplies Inventory and Expense Using IDEA You have been assigned the task of testing the client‘s Supplies Expense based on purchase records and the year-end inventory count. ELM‘s unaudited Trial Balance shows a recorded amount of $33,650 for Supplies Expense during the 4th quarter. Per the client, Supplies Expense consists of the all supplies indirectly used in the factory, but which do not get included in the cost of the manufacturing process. These products are all inventory units beginning with E, Q, or J. Assume that the cost of supplies remained constant throughout the quarter. Required: a. Using the information given about beginning balances, purchases, ending counts, and the vendor price list, recalculate Supplies Expense. For the purposes of this exercise, ignore any taxes or shipping charges and base costs solely on the price list. b. Does ELM‘s recorded Supplies Expense appear reasonable? Would the auditor perform any further detail testing on Supplies Expense? Explain your reasoning.

Solution: Based on the question asked, the first step is to calculate the quantities of supplies used, which will then be multiplied by the cost per unit on the price list. 1. First, extract beginning quantities of supplies from the Ending Inventory Balances 2020 – 3rd Q data set.

Because beginning quantities and ending counts are givens, the first calculation is summarizing the quantities purchased. NOTE: If exercise 9.72 was completed, this step is already completed – you may use the Goods Received 4th Q summarization from step 4 of the solution to 9.72 and skip to step 4. If not, follow the next two steps. 2. Extract purchases received during the fourth quarter from the Purchases 2020 – 4th Q database.

3. Summarize the Goods Received 4th Q by PARTNO. 1-265 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. Join the Supplies Beginning Balances (primary) with the Goods Received 4th Q Summarization (secondary) by PARTNO, including items from the primary database (Supplies).

5. Summarize the Inventory Count by PARTNO (Note: This was already done in both 9.71 and 9.72, and the Inventory Count Summarization may be used from there).

6. Join the Supplies Available for Use with the Inventory Count database by PARTNO.

7. Calculate the quantity of supplies used during the year as QUANTITY + RECAMOUNT – COUNTSUM.

8. Join the SUPPLIES_USED database with the Combined Materials and Supplies Price List database.

9. Multiply the SUPPLIES_USED by the COST to obtain the total costs, ensuring the units are consistent (here they are).

10. Finally, use field statistics in the properties window to obtain the sum of the TOTCOST of supplies.

The total recalculated Supplies Expense is $36,713.22. According to the exercise, the client reported Supplies Expense of $33,650. The difference ($3,163) is far less than performance materiality of $25,000. As a result, the auditor is unlikely to perform any further detail testing on the supplies expense account.

CHAPTER 10 Finance and Investment Cycle LEARNING OBJECTIVES Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

Describe the finance and investment cycle, including typical source documents.

1, 2, 3, 4,

23, 24, 25

Identify significant accounts and relevant assertions related to the finance and investment cycle.

9, 10, 13, 14

Discuss the risk of material misstatement in the finance and investment cycle, with a specific focus on improper valuation and disclosure.

17, 18, 21

28, 31, 32

Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion in the finance and investment cycle.

5, 6, 7

27, 35, 39, 45

Give examples of tests of controls to test the operating effectiveness of internal controls in the finance and investment cycle.

Give examples of substantive procedures in the finance and investment cycle and relate them to assertions about significant account balances at the end of the period.

11, 12, 15, 16, 19, 20, 22

26, 30, 34, 35, 36, 38, 39, 40, 41, 42, 44, 45, 46, 47, 48, 49

51(*), 52(*), 53(*), 54(*), 55(*), 56(*), 57, 58, 59, 60, 61, 62(*), 63(*), 64(*)

Apply your knowledge to perform audit procedures in the finance and investment cycle and evaluate the findings of your tests.

56, 62(*), 63(*)

51(*), 52(*), 53(*), 54(*), 55(*),62(*), 63(*), 64(*)

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 10.1

The authorization for investments usually takes place at the highest levels of the organization. An investment philosophy may be stated or endorsed by the board of directors and specific authorization for each transaction may come from the CEO or CFO. Such investments may involve millions of dollars and may be instrumental to the strategic objectives of the organization, commanding the authorization of senior management

10.2

Actions by the board of directors or finance committee are usually required as authorization for notes payable. Auditors would want to read all minutes of the board and executive committees, extracting copies of all financial matters, including notes payable authorizations.

10.3

Typically, a company will require information from a broker’s advice to correctly account for the initial purchase of an investment security. However, maintaining correct accounting depends on the nature of the investment. For example:  Held to Maturity debt investments may be amortized, which will require appropriate amortization tables  Available for Sale and Trading securities require mark-to-market adjustments, which will require publicly available market values from either a broker or a publication such as The Wall Street Journal.  Equity method investments require obtaining copies of the investees financial statements, as well as records of any dividends received.  Even cost basis investments must be analyzed for potential other-than-temporary declines in value.

10.4

The activities a company performs to reconcile the accuracy of marketable securities from an investment listing to the actual securities depends on whether the client holds the securities. If the securities are held by a brokerage firm, the company may receive periodic statements from the brokerage documenting the securities currently owned. However, if the company holds the securities, the company should perform a periodic securities count that reconciles the name of the company, the interest rate for bonds, the dividend rate for preferred stocks, the due date for bonds, any known serial numbers, and other identifying information. This reconciliation should be performed on a regular basis by a company.

10.5

A compensating control for finance and investment cycle accounts is a control feature used when the company does not specify a standard control procedure (such as strict separation of functional responsibilities). In the area of finance and investment, the compensating control feature is the involvement of two or more persons in each kind of important functional responsibility. If involvement by multiple persons is not specified, then oversight or review can be substituted. For example, the board of directors can authorize purchase of securities or creation of a partnership. The CFO or CEO can carry out the transactions, have custody of certificates and agreements, manage the partnership or the portfolio of securities, oversee the record keeping, and make the decisions about valuations and accounting (authorizing the journal entries). These are rather normal management activities, and they combine several responsibilities. The compensating control can exist in the form of periodic reports to the board of directors, oversight by the investment committee of the board, and internal audit involvement in making a periodic reconciliation of securities certificates in a portfolio with the amounts and descriptions recorded in the accounts.

10.6

According to auditing standards (AU-C 540, AS 2501) specific relevant aspects of control over the production of accounting estimates include:      

Management communication of the need for proper accounting estimates. Accumulation of relevant, sufficient, and reliable data for estimates. Preparation of estimates by qualified personnel. Adequate review and approval by appropriate levels of authority. Comparison of prior estimates with subsequent results to assess the reliability of the estimation outcomes. Consideration by management of whether particular accounting estimates are consistent with the company‘s operational plans.

10.7 Because transactions in the investing and financing involve large amounts of cash, authorization at the highest levels of governance is critical. Often, this goes all the way to the board of directors. Some transactions which are generally approved by the board include:    

Issuance of capital stock Treasury stock repurchases Issuance, sale, or purchase of bonds Large bank loans

  

Purchase or sale of buildings and other large assets Mergers and acquisitions Dividends

If there is no evidence of approval of these transactions in the board of directors minutes, the auditor should make inquiries to ensure that the transactions were approved. 10.8

When bonds and notes are paid off, they are typically returned to the company. The instruments should then be either marked as paid (canceled), or destroyed. Companies with large bond issuances will often contract with a third party to destroy the bonds. If the bonds or notes are not properly canceled or destroyed, an employee or anyone else who gained custody of the instrument could resell the debt to an unsuspecting investor. Although the note or bond would not be valid, this could still cause a significant headache for the company. Further, an unscrupulous employee with inadequate segregation of duties could potentially pay out a bond for a second time.

10.9 Specific assertions typical of investment account balances are that:     

Investment securities are on hand or are held in safekeeping by a trustee. The accounting for investment cost and market value is appropriate. Controlling investments are accounted for by the equity method. Investment income has been received and recorded. Investments are adequately classified and described in the balance sheet, including disclosures of restrictions, pledges, or liens.

10.10

10.11

Some of the typical areas for concern in the investment accounts are: 

Valuation of investments at cost, market, or value impairment that is other than temporary.



Determination of significant influence relationship for equity method investments.



Impairment of goodwill.



Capitalization and continuing valuation of intangibles and deferred charges.



Propriety, effectiveness, and risk disclosure of derivative securities used as a hedge of exposure to changes in fair value (fair value hedge), variability in cash flows (cash flow hedge), or fluctuations in foreign currency.



Determination of the fair value of derivatives and securities, including valuation models and the reasonableness of key assumptions.



Realistic distinctions of research, feasibility, and production milestones for capitalization of software development costs.



Adequate disclosure of restrictions, pledges, or liens related to investment assets.

Securities held by trustees or brokers should be confirmed, and the confirmation request should seek the same descriptive information as that obtained in a physical inspection by the auditor. That is, the name of the company, number and class of shares, and any restrictions on the stock. The broker can also confirm the market value and the trading activity in the securities for the period. This is a critical procedure to audit the existence assertion of investment securities.

10.12 As a starting point for auditing fair value estimates, auditors will typically attempt to understand the client‘s process for creating the fair value estimate. To this end, auditors can make these inquiries:     

Who prepares estimates? When are they prepared? What data is used? Who reviews and approves the estimates? Have you compared prior estimates with subsequent actual events?

Once an understanding of the estimation process is obtained, auditing fair value measurements is similar to auditing other accounting estimates. Substantive procedures for auditing accounting estimates include determining whether (1) the valuation principles are acceptable under the financial reporting framework, (2) the valuation principles are consistently applied, (3) the valuation principles are supported by the underlying documentation, and (4) the method of estimation and the significant assumptions are properly disclosed according to GAAP. 10.13

Some of the typical assertions found in owners‘ equity descriptions and account balances are: •

The number of shares shown as issued is in fact issued.

•

No other shares (including options, warrants, and the like) have been issued and not recorded or reflected in the accounts and disclosures.

•

The accounting is proper for options, warrants, and other stock issue plans, and related disclosures are adequate.

10.14

•

The valuation of shares issued for noncash consideration is proper in conformity with accounting principles.

•

The board of directors has authorized all owners‘ equity transactions.

Some of the important assertions found in the long-term liability accounts are: •

All material long-term liabilities are recorded.

•

Liabilities are properly classified according to their current or long-term status. The current portion of long-term debt is properly valued and classified.

•

New long-term liabilities and debt extinguishments are properly authorized.

•

Terms, conditions, and restrictions relating to noncurrent debt are adequately disclosed.

•

Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate.

•

All important contingencies are either accrued in the accounts or disclosed in footnotes.

•

Liabilities are appropriate valued.

10.15

a. Confirmations for stockholder equity: Capital stock may be subject to confirmation when independent registrars and transfer agents are employed. Such agents are responsible for knowing the number of shares authorized and issued and for keeping lists of stockholders‘ names. The basic information about capital stock, such as number of shares, classes of stock, preferred dividend rates, conversion terms, dividend payments, shares held in the company name, expiration dates, and terms of warrants and stock dividends and splits, can be confirmed with the independent agents. Many of these items can be corroborated by the auditors‘ own inspection and reading of stock certificates, charter authorizations, directors‘ minutes, and registration statements. However, when there are no independent agents, most audit evidence is gathered by vouching stock record documents (such as certificate book stubs). When circumstances call for extended procedures, information on outstanding stock (very small, closely held companies) may be confirmed directly with the holders. b. Notes and bonds payable: Written confirmations are usually obtained from the independent parties. If the notes are payable to banks, the standard bank confirmation may be used. Formal debt instruments can be confirmed by letter to the holder or his or her agent. The confirmation requests should include questions of amount, interest rate, due date, collateral, restrictive covenants, and other terms. To aid in the search for unrecorded liabilities, confirmation requests should be sent to lenders with whom the company has done business in the recent past even if no liability balance is shown at the confirmation date.

10.16

The information that can be confirmed when independent registrars and transfer agents are utilized by the client include the items as features of interest in the answer to review question 10.9. Many of these items can be corroborated by the auditors inspecting the reports from these agents, reading the minutes of the directors, and reading prospectuses.

10.17

Off-balance-sheet information refers to information that relates to obligations and commitments assumed by the clients that do not appear on the balance sheet as current or long-term liabilities. Such information should be disclosed by the client in the footnotes to the financial statements. Therefore, the auditors must be alert to these items and gather evidence that will allow the auditors to determine whether the footnote disclosure is adequate. Such information includes leases, endorsements on discounted notes or others‘ obligations, guarantees, repurchase or remarketing agreements, commitments to purchase at fixed prices, commitments to sell at fixed prices, legal judgment, litigation, and pending litigation.

10.18

If a company does not monitor notes payable for due dates and interest payment dates in relation to financial statement dates, these misstatements can appear in the financial statements:

10.19



Understated interest expense and understated current liabilities resulting from failure to accrue interest expense.



Understated current liabilities and overstated long-term debt resulting from failure to classify the ―current portion of long-term debt‖ in current liabilities.

The unfortunate auditors learned that they should know about the requirements of the securities acts, they should use experts in the area if they do not have expertise themselves, and they can ask the SEC for advice in advance. When suspecting violation of U.S. securities laws (SEC), an auditor should take the factual and descriptive information to a competent attorney for review and an opinion. Auditors can advise company management to consult with the SEC about the necessity for conforming to the law in connection with contemplated transactions.

10.20

Auditors could discover the off-balance-sheet financing described in Case 10.2 (―Off-Balance Sheet Inventory Financing‖) by (1) making inquiries about large and unusual financing transactions, (2) noticing the large ―sale‖ transaction when performing analytical comparisons of monthly or seasonal sales, (3) examining the sales contract, (4) discussing with management the business purpose of the transaction, and 1-275 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

(5) inquiring in secretary of state records for identification of customer company incorporators and registered agent. 10.21

Related parties might inflate values with spurious transactions, finally putting them in financial statements of an auditee (―Go for the Gold‖ case).

10.22

First, it is essential that the auditors have expertise in the client‘s industry. When such expertise is lacking, the auditors must secure the necessary knowledge by hiring knowledgeable personnel or a consultant with the appropriate knowledge. Second, the auditor must take into account the historical nature of films of this type. While management may expect one film to be as successful as recent films of a similar genre, the auditor must take into account the full range of successful and unsuccessful films. A statistical analysis could generate a range of values, which the auditor may use. Within this range, the auditor would likely take a conservative estimate. This may be at odds with management who may want to take a more aggressive approach to the revenue estimate. Third, the auditors must analyze the assumptions used by management to reach their estimates. These assumptions may be based on overly optimistic projection of ticket sales, DVD sales, and other merchandising agreements.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 10.23

a. b. c.

Incorrect Incorrect Correct

Incorrect

Because of the large amounts of the items, a substantive approach is preferred. Auditors can never ignore internal controls. Controls must be reviewed (and tested for public companies); however, a substantive approach is preferred. This would be the least effective approach.

10.24

a. b. c. d.

Correct Incorrect Incorrect Incorrect

This is the purpose of covenants. The covenants are to protect the lender. Auditors are not involved in structuring client transactions. The board of directors should protect the shareholders from too much debt.

10.25

a. b. c. d.

Incorrect Incorrect Correct Incorrect

This is a related party, but the definition is incomplete. This is a related party, but the definition is incomplete. This is the complete definition. This is a related party, but the definition is incomplete.

10.26

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

This ignores accruals. This procedure does not lend itself to statistical sampling because of the low volume of transactions. This also ignores dividends receivable. Independent evidence from an outside dividend reporting service is the best evidence for existence, completeness, and valuation.

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Correct

Incorrect

10.27

10.28

This should be prevented by controls, not the audit. See answer (a). The danger is that someone might move securities so the auditor counts them twice. This is a danger, but audits cannot be relied upon to detect counterfeit securities. Long-term notes payable are not recorded with normal purchases. Authorization by the board of directors is the most important control procedure for long-term notes payable. This control is more closely related to presentation and disclosure, but is not closely related to material misstatements of long-term notes payable.

Incorrect

b. c.

Incorrect Correct

Incorrect

10.30

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Related parties can own the bonds, but their ownership must be disclosed. This is not the responsibility of external auditors. This is not a primary responsibility of external auditors. Among the choices available, obtaining an opinion from legal counsel is the best response. The legality of a bond issue is important although not the only important thing.

10.31

a. b. c. d.

Incorrect Incorrect Incorrect Correct

A company does not necessarily need to use a transfer agent. These are usually approved by directors. Stock dividends are recorded at fair market value. Capital stock transactions are important by definition, and the directors should have approved all of them.

10.32

Incorrect

Correct

Incorrect

The approximate market value should be shown as the account balance on the balance sheet, not in parentheses. The classification of the investment is determined by the maturity or intent, not by the profitability of the investment. Losses on investment should be recorded in the accounts and shown in the financial statements. (Losses on trading securities in the income statement; loss on available-for-sale securities in the equity section.) The loss would not be shown separately in the equity section of the balance sheet.

a. b. c.

Incorrect Incorrect Incorrect

Correct

Incorrect

b. c. d.

Incorrect Incorrect Correct

Correct

b. c.

Incorrect Incorrect

Incorrect

10.29

10.33

10.34

10.35

This control procedure is more closely related to efficiency and effectiveness of operations than financial reporting. The existence of goodwill is determined based on an excess of purchase price over fair value of identifiable assets in a purchase transaction. Goodwill is unlikely to be understated in a purchase transaction. Because goodwill is not a separately identifiable asset, valuation is a level 3 fair value estimate and is generally considered a substantial risk in an audit. Rights & Obligations is not a relevant assertion in the audit of goodwill.

This is a substantive test that has little to do with controls. Prepaid expense would have to be calculated based on the payment date. This might provide evidence regarding imputed interest expense, but only if all liabilities are recorded. Imputed interest generally requires a detailed test considering the specific terms of the debt. ―Detect unrecorded liabilities‖ is the best response, but remember that the procedure might be ineffective if the interest expense on an unrecorded liability is also unrecorded. This is somewhat true because the bank won‘t let the auditor in without permission. However, (d) is more important. It is unlikely that either would be able to detect forged securities. The auditor could do this without the client. A client representative should be present to acknowledge return so the auditor will not be accused of theft. Stock certificates should be defaced but retained so the auditors can actually see the canceled certificate. See (a). The defaced certificates should be retained so the auditors can see that they have not been issued. See (c).

10.36

Incorrect

Correct

Incorrect

Correct

Incorrect

Capital stock transactions are important by definition, and the directors should have approved all of them. Sales of stock should be traced to cash receipts, but not necessarily other transactions. Purchases of treasury stock should be traced to cash disbursements, but not sales. If shares are sold, the numbered certificates will not be available.

10.38

a. b. c. d.

Incorrect Incorrect Correct Correct

Stock splits have no effect on retained earnings. This would not go to beginning balance of retained earnings. These should be authorized by the board of directors. Gain or loss on treasury stock transactions should be audited.

10.39

Correct

b. c. d.

Incorrect Incorrect Incorrect

To conceal fraud related to marketable securities, collusion between those responsible for record keeping and custody would be required. The possibility of collusion is reduced if no direct contact between responsible parties exists. Securities must be registered in the name of the company. Custody and authorization are incompatible duties. How the trust company secures the assets has nothing to do with preventing fraud at the company.

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Incorrect

Correct

10.37

10.40

10.41

10.42

Registrar/transfer agent has no record of restrictions on the payment of dividends. The number of shares issued and outstanding is the record kept by the registrar/transfer agent. Registrar/transfer agent has no record of guarantees of preferred stock liquidation value. Registrar/transfer agent has no record of the number of shares subject to agreements to repurchase.

This ignores accruals. The interest earned depends on the effective rate, not the face rate. The audit program for long-term investments includes making an independent computation of revenue (such as dividends and interest). For example, bond certificates contain information about interest rates, payment dates, issue date, and face amount that the auditor can use to recalculate bond interest earned, including amounts accrued but not collected, during the period the auditee has held the investment. See (a). Banks do not open safe deposit boxes. Auditors normally do not rely on tests of transactions for securities. The auditor normally needs to count the certificates. Banks do not know what is added to or removed from safety deposit boxes. Securities should be inspected simultaneously with the verification of cash and the count of other liquid assets to prevent transfers among asset categories for the purpose of concealing a shortage. If this procedure is not possible but the securities are kept by a custodian in a bank safe deposit box, the client may instruct the custodian that no one is to have access to the securities unless in the presence of the auditor. Thus, when finally inspecting the securities, the auditor may conclude that they represent what was on hand at the balance-sheet date. This is not a suitable objective for analytical procedures because gains and losses can result from unique circumstances. The auditor may develop expectations regarding the completeness assertion for unrecorded investment income from stocks by using dividend records published

by standard investment advisory services to recompute dividends received. Interest income from bond investments can be calculated from interest rates and payment dates noted on the certificates. Income from equity-based investments can be estimated from audited financial statements of the investees. Thus, applying an expected rate of return to the net investment amount may be an effective means of estimating total investment income. The auditor must evaluate management‘s plans for the securities. This is not a suitable objective for analytical procedures because market prices are volatile and difficult to predict.

c. d.

Incorrect Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

10.45

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This is a management decision. This might be a good cash disbursements control, but (d) is more important. This is a management decision. Control is enhanced when different persons or departments authorize, record, and maintain custody of assets for a class of transactions. Authorization of notes payable transactions is best done by the board of directors.

10.46

Correct

Events such as the renewal of the note payable do not require adjustment of the financial statements but may require disclosure. Accordingly, the auditor should determine that the renewal had essentially the same terms and conditions as the recorded debt at year-end. A significant change may affect the presentation of notes payable such as a reclassification from short term to long term.

10.47

a. b.

Incorrect Correct

Incorrect

Review of minutes for authorization is an important audit procedure. The registrar would not have information related to the investor or market information. The broker in particular would have information on the sale of investments to the client. Determining market value is an important audit procedure.

10.48

a. b. c. d.

Incorrect Incorrect Correct Incorrect

Review of minutes for authorization is an important audit procedure. The registrar would have record of stock sold. Market price is not important in valuing shareholder‘s equity. Obtaining management representation is an important procedure.

10.49

a. b.

Incorrect Correct

There is no evidence that the certificates are forgeries. The main concern is that someone sold the IBM securities (in order to use the cash) and repurchased the securities at a later date. This may have been done for personal use or for the company.

10.43

10.44

If bonds are unrecorded, nothing will show up in bond premium or discount. This has nothing to do with completeness of bonds payable. The recorded interest expense should reconcile with the outstanding bonds payable. If interest expense appears excessive relative to the recorded bonds payable, unrecorded long-term liabilities may exist. If the payable account is incomplete, the bond will not be on the listing the auditor uses to select confirmations. Held-to-maturity debt is recorded at cost. By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to the long-term debt, unrecorded interest-bearing obligations may be outstanding. The auditor is usually less concerned about existence than completeness. If the bond is unrecorded, it will not be in the ledger.

Incorrect

There is no evidence that the securities are not properly presented on the balance sheet. The fact that there is a certificate for IBM stock indicates that the company still owns 100 shares of IBM.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 10.50

Internal Control Questionnaire for Equity Investments The three questions in the problem can be called ―environment‖ questions. Questions specific to management assertions are: Existence or Occurrence a. Are marketable securities investment transactions supported by invoices from brokers or other documents supporting securities not obtained through brokers? b. For investments held by the company, are CUSIP numbers recorded for each certificate and are the CUSIP numbers periodically compared to the securities being held? Completeness c. Do the cash disbursements procedures contain directions for identifying and accounting for investments in marketable securities? d. Are subsidiary records of investments kept? Are they reconciled periodically with a control account? Are sales proceeds analyzed to account for gains and losses? Rights and Obligations e.

Are securities recorded in the company‘s name or in broker accounts in the company name?

Valuation or Allocation f.

Are investments representing control over investees accounted for by the equity method?

g. Does the controller approve investment security transactions for proper calculation of interest purchased in bond transactions, special terms of options, warrants, and other features of complicated investment securities? h. Does the controller‘s office receive notice of dividends declared in companies in which investments are held so accounting can match the proper period? Do accountants have instructions to accrue interest to the date of the financial statements? Presentation and Disclosure i. Does the board of directors, vice president of finance, or treasurer indicate in writing the intent of the management in connection with classifying investment securities?

10.51

Investment Securities a.

The objectives (specific assertions) for the audit of investment securities are to obtain evidence regarding the:       

The following audit procedures should be undertaken with respect to the audit evidence for existence and cost valuation of Bass‘s held-to-maturity investment securities:        

Existence of the investment securities at the balance-sheet date. Ownership of the investment securities. Accurate cost and market value of the investment securities. Proper classification of the investment securities. Proper presentation and disclosure of the investment securities in the financial statements. Proper recognition of interest income. Proper recognition of investment gains and losses.

Inspect and count securities in the company‘s safe and safe deposit box. Examine brokers‘ statements to obtain assurance that all transactions were recorded. Examine documents in support of purchases and sales of investment securities. Inspect the minutes of the board of directors meetings. Obtain a client representation letter that confirms the client‘s representations concerning the held-to-maturity investment securities. Verify the calculation of interest income. Review the propriety of the presentation and disclosure of the securities in the financial statements. Make certain that the client representation letter includes the proper assertions concerning the securities portfolio.

The following audit procedures should be undertaken with respect to the audit evidence regarding Bass‘s controlling equity investment in Commercial Industrial, Inc.         

Inspect and count securities in the company‘s safe and safe deposit box. Examine documents in support of purchases and sales of investment securities. Inspect the minutes of the board of directors meetings. Review the audited financial statements of the (25 percent) investee. Verify that the equity method of accounting was used for carrying value of the investment in Commercial Industrial. Obtain a client representation letter that confirms the client‘s representations concerning the controlling interest. Verify the calculation equity method income. Review the propriety of the presentation and disclosure of the securities in the financial statements. Make certain that the client representation letter includes the proper assertions concerning the controlling interest.

Audit procedures should be undertaken with respect to obtaining audit evidence about the classification of held-to-maturity securities in the Bass portfolio? (Hint: Review the audit program in Appendix 10B-3.) •

Determine the proper classification of securities in the categories of held-to-maturity, available-for-sale, and trading securities. (a) (b) (c) (d) (e)

•

Determine whether facts support management‘s intent to hold securities to maturity. (a)

(b) (c)

Determine the company‘s financial position, working capital requirements, results of operations, debt agreements, guarantees, and applicable laws and regulations. Study the company‘s cash flow forecasts. Obtain written management representations confirming proper classification with regard to intent and ability.

Suppose the held-to-maturity portfolio (excluding the investment in Commercial Industrial, Inc.) is carried at cost in the amount of $3,450,000. Audit procedures with respect to obtaining audit evidence about the market (fair) value of this portfolio might include: •

Determine whether the securities are actively traded in a broad market.

•

Determine an audit valuation of fair value when appropriate. (a) (b)

Inquire about management‘s intent regarding classifications. Study written records of investment strategies. Review records of past investment activities and transactions. Review instructions to portfolio managers. Study minutes of the investment committee of the board of directors.

Obtain published market quotations. Obtain market prices from broker-dealers who are market makers in particular securities.

Suppose the auditor determines that the held-to-maturity portfolio (excluding the investment in Commercial Industrial, Inc.) has an aggregate market (fair) value of $2,970,000. Audit procedures with respect to obtaining audit evidence regarding a value impairment that might be ―other than temporary‖? (Hint: Review the audit program in Appendix 10B-3.) •

Determine whether value impairments are ―other than temporary‖ by considering evidence of the following: (a) Fair value is materially below cost. (b) The value decline is due to specific adverse conditions. (c) The value decline is industry or geographically specific. (d) Management does not have both the intent and ability to hold the security long enough for a reasonable hope of value recovery. (e) The fair value decline has existed for a long time. (f) A debt security has been downgraded by a rating agency. (g) The financial condition of the issuer has deteriorated. (h) Dividends of interest payments have been reduced or eliminated.

10.52

Lease Accounting. Union Pacific Corp. a.

10.53

Union Pacific would prefer accounting for the lease as an operating lease for a number of reasons: 

The charge to income for interest and depreciation under capital lease is higher in early years than rent expense charged for an operating lease.



Treating the lease as an operating lease reduces the asset base and improves return on assets.



Treating the lease as an operating lease avoids recording the debt for a capital lease, which results in a lower debt to equity ratio.

The auditor would need to review an independent estimate of the value of the building and of its expected useful life. The auditor would also review the terms of the lease for life, renewal options, rental rate, additional rental costs, and so on. The auditor may also want to confirm the terms of the lease with the lessor. Finally, the auditor would test the client‘s calculations for the lease treatment under SFAS 13 and obtain representation from the client that the assumptions are appropriate.

Securities Examination and Count a.

Instructions to be given to the assistant regarding the examination of the securities kept in the safe deposit box include the following: (1)

A copy of the client‘s inventory of the contents box should be obtained and used in connection with the inspection of the securities. Comparing the contents of the box and the inventory will provide assurance that all securities listed in the inventory are on hand. (The validity of the inventory will be determined by examination of the transactions pertaining to investments.) The copy of the inventory, after being checked, should be added to the audit documentation as evidence of work performed.

(2)

The bank‘s record of persons entering the deposit box should be examined to determine that only authorized persons have had access to the box and that there was no entry to the box between December 31 and January 11. Entry to the box between those dates may be an indication that a security was returned to safekeeping after being ―borrowed‖ at year-end. The security may have been ―borrowed‖ and used as collateral to obtain cash to cover a shortage at December 31.

(3)

The assistant should be instructed to insist that the treasurer be present while the securities are being examined. The treasurer‘s presence will deter any future claim that, if a security is missing at a later date, the assistant took it.

(4)

The following details of the securities should be examined: (a)

The name of the registered owner (Demot Corp.) appearing on each security other than bearer bonds should be noted.

(b)

The dates stamped on stock certificates giving the dates that the certificates were prepared should be noted and subsequently compared with cash disbursements.

(c)

The name of the corporation issuing the security and the class of the security (Class A, Par Value, 1st Preferred, etc.) should be noted for assurance that a lower priced security (perhaps somewhat similar in corporate name or a different security of the issuing corporation) has not been substituted for a higher priced security.

(d)

The face value of bonds and the number of shares represented by each stock certificate should be compared with the inventory to determine that the entire amount of the corporation‘s holdings of each security is on hand.

(e)

The serial numbers of the securities should be compared with those on the inventory and, for those securities carried over from the prior year, compared with the serial numbers of securities listed in the prior-year audit documentation. A change in serial numbers that cannot be properly explained may be an indication of manipulation of the securities.

(f)

The certificate should be read to ascertain that interest rates and payment dates for bonds and the dividend rates and payment dates, if given, for preferred stocks. This information may be used later in the verification of investment income.

(g)

Bonds should be examined to determine maturity dates. Maturity dates are needed for checking the computation of the amortization of bond premiums or discounts.

(h)

Coupon bonds should be inspected to determine that no past due interest coupons are unclipped and all future interest coupons are attached.

(i)

The assistant should be alert for any obvious alterations to securities or forged certificates.

(j)

The assistant should also examine the reverse side of the certificates to determine whether they have been endorsed for transfer. The presence of an endorsement may be an indication that the security had been converted temporarily for some use, perhaps fraudulent, in the past.

(k)

Any worthless securities on hand should also be examined and compared with the client‘s inventory and with prior audit documentation. Any missing securities should be noted for subsequent follow-up to determine that the client had received the funds derived from the sale or redemption of securities deemed worthless in error.

The treasurer‘s entry into the safe deposit box on January 4 violated the auditor‘s control over liquid assets that must be counted simultaneously or kept under control until counted to avoid the substitution of a counted asset for an uncounted asset in an attempt to conceal a shortage. The auditor would probably apply the following additional procedures: (1) (2) (3) (4) (5)

Reconcile bank balances at both year-end and at the count date. Obtain a bank confirmation as of the count date. Examine cash entries between year-end and the count date for any unusual entries. Examine all investment transactions taking place between the balance-sheet date and the count date to verify the amount of the investments at the balance-sheet date. If the client keeps a large fund of cash on hand, make a surprise count of the cash fund.

(6) (7)

10.54

Audit Objectives and Procedures for Investments 1.

Investments are properly described and classified in the financial statements. e.

(best)

Verify that transfers from the trading portfolio to the held-to-maturity investment portfolio have been properly recorded.

(possible)

Trace investment transactions to minutes of the board of directors meetings to determine that transactions were properly authorized (especially for the portfolio classification).

Recorded investments represent investments actually owned at the balance-sheet date. f.

Obtain positive confirmations as of the balance-sheet date of investments held by independent custodians.

Investments are properly valued at the balance-sheet date. d.

10.55

Review the transactions since year-end relating to any other assets, such as mortgages owned, to determine whether any substitutions have been made. Visit the Chamber of Commerce and take a look at the photograph.

Determine whether any other-than-temporary impairments in the carrying value of investments have been properly recorded.

Intangibles 1.

a. Machinery Patents

17,000 17,000

To transfer cost of improving machinery to the fixed asset account Cost of Goods Sold Patents

4,000 4,000

To record straight-line amortization of patents for the year b. Inspect the patent document and vouch to the work orders for machinery improvement. Recalculate amortization of patent. 2.

a. Licensing Agreement No. 2 Revenue Received in Advance

1,000 1,000

To record unearned revenue in a deferred credit account b. Vouch transaction to the documentation to support the receipt of revenue. Vouch cash to deposit in bank account. 3.

a. Retained Earnings Loss from Flood Licensing Agreement No. 1

30,000 20,000 50,000

To account for the $30,000 prior period adjustment and the $20,000 current year loss. 1-286 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

b. Vouch to insurance documents for claims. Review local news for evidence of explosion and/or flood. 4.

a. Cost of Goods Sold Licensing Agreement No. 2

5,000 5,000

To record amortization for the year on straight-line basis, 10-year life b. Recalculate amortization. 5.

a. Retained Earnings Goodwill

24,000 24,000

To correct the accounting error of last year of improperly capitalizing an expense item b. Review goodwill account. Vouch to original calculation of goodwill to ensure all expenses in the account are capital expenses. 6.

a. Equipment Accounts Receivable Nontrade Leasehold Improvements

8,500 2,500 11,000

To record equipment in the proper account and to record a receivable for the real estate taxes Amortization Expense —Current Year Amortization Expense—Error Correction Leasehold Improvements

1,500 1,500 3,000

To record current amortization and correct the error of failure to record amortization of leasehold improvements on a straight-line, 10-year basis. No adjustment to depreciation of equipment because it was acquired in December. b. Vouch transaction to purchase order for equipment and work orders for leasehold improvements. Recalculate amortizations. 7.

a. Retained Earnings Organizational Expenses

29,000 29,000

To write off organizational expenses improperly capitalized in prior period b. Vouch transaction to original expenses for proper amounts. Review Retained earnings for propriety of other items.

10.56

Loan Covenants Note to instructor: Students may wish to reference http://www.loanuniverse.com/covenant.html in responding to this question. a.

Banks usually add covenants to accomplish the following objectives:     

Maintain loan quality. Keep adequate cash flow. Preserve equity. As a measure to improve the weakness in a borrower with a known weakness in its capital structure. Keep an updated picture of the borrower‘s financial performance and condition

Common loan covenants Things that the borrower must do: (1)

Maintain hazard insurance/content insurance. b.

To ensure that if the collateral is damages the company will be reimbursed and can pay off the loan. The borrower is required to keep insurance coverage on the plant/equipment or inventory in order to safeguard against the catastrophic loss of collateral.

c. Confirm insurance with the insurance company; review insurance policy at client. (2)

Maintain key-person life insurance. b.

To protect the lenders from loses incurred by the loss of a key employee. This insures the life of the indispensable owner or manager without whom the company could not continue. The lender usually gets an assignment of the policy.

c. Confirm insurance with the insurance company; review insurance policy at client

(3)

Make all payments of taxes /fees /licenses. b.

To protect the lender from government seizure of property. Borrower agrees to keep those expenses up-to-date as failure to pay would result on the assets of the company being encumbered by a lien from the government, which would take precedence to the one from the bank.

c. (4)

Review cancelled checks for payments.

Provide financial information on borrower and guarantor. b.

Protect the lender from non-payment due to deteriorating financial condition. Borrower agrees to submit financial statements for the continuing assessment by the bank. Financial statements are usually submitted yearly while account receivable can be required every month.

(5)

Review financial information; review financial reports of guarantor (if any); confirm with lender the receipt of financial information.

Maintain a certain level in key financial ratios. The borrower is required to maintain a certain level in key financial ratios such as: (a) (b) (c) (d)

Minimum quick and current ratios (liquidity) Minimum Return On Assets And Return On Equity (profitability) Minimum equity, minimum working capital Maximum debt to worth (leverage)

b. Financial ratios provide an analysis of the financial condition of the borrower and help the lender determine the likelihood of repayment. In addition, the borrower might be prevented from doing certain things via loan covenants. c. Review ratios; vouch numbers used in ratio calculations to the source information (6)

Make no change of management or merger without prior approval. b. Guarantees the continuing existence of your borrower and will impede the deterioration of financial condition due to merger with an unknown entity. c. Compare organizational charts with prior years; review minutes of the board of directors meetings; review local news sources.

(7)

Obtain no more loans without prior approval. b. Ensures that the company does not take on excessive debt affecting the quality of the original loan. c. Review long term debt accounts and interest expense accounts.

(8)

Make no dividends/withdrawals or limited dividend withdrawals. b. In situations in which the net worth is being eroded by the extraction of capital in the form of dividends or stockholder‘s withdrawal, the lender might find it necessary to restrict the amount of money that can be taken out of the company. In subchapter-S corporations, it is not uncommon to limit withdrawals to the owner‘s tax liability. c. Review dividend account; review cash disbursements for payments to registrar or to investors.

D. It is important for an auditor to ensure that the client is in compliance with debt covenents because if the client is in violation of the debt covenants the lender may be able to call the debt (i.e. ask for immediate payment). Such a demand for cash, if the amount is large, may create a going concern issue for the client.

10.57

Long-Term Financing Agreement a.

The procedures you should employ in examining the Broadwall loans are as follows:       

Broadwall‘s financial statements should disclose the following information concerning the loans from its president:   

10.58

Obtain an understanding of the business purpose of the loans made by the president. Confirm the loans, including terms, by direct communication. Recompute interest expense and interest payable. Review minutes of meetings of the board of directors for proper authorization. Verify payments made during the year and transactions after the year-end. Read the notes to the financial statements regarding the loan agreements and evaluate the adequacy of disclosure and compliance with restrictions. Obtain a management representation letter.

The nature of the related-party relationship. The dollar amounts of the loans. Amounts due the president and, if not otherwise apparent, the terms and manner of settlement.

Bond Indenture Covenants In each case any actual failure to comply would need to be reported in a footnote to the statements in view of the possible serious consequences of advancing the maturity date of the loan. The individual audit steps follow:

10.59

Check balance sheets at beginning and through the previous fiscal year for working capital ratio. If under 2:1, check compensation of officers for compliance with limitation.

Examine client‘s copies of insurance policies or certificates of insurance for compliance with the covenant, preparing schedule of book value, appraised or estimated actual value, and coverage for report. Confirm policies held with trustee.

Examine vouchers supporting tax payments on all property covered by the indenture. By reference to the local tax laws and the vouchers, determine that all taxes have been paid before the penalty-free period expired. If vouchers in any case are inadequate, confirm with trustee who holds the tax receipts.

Common Stock and Treasury Stock: Substantive Audit Procedures Common Stock

Treasury Stock

Existence (a)

Verify authorized shares with reference to corporate charter.

(b)

Confirm outstanding shares with owners.

(c)

Count outstanding shares as shown in the stock record book stubs.

(a)

Inspect the certificates held as treasury stock.

(d)

Verify authorization in board minutes to issue new shares.

(e)

Obtain written representations about the number of shares authorized, issued, and outstanding.

Completeness

(f)

Reconcile the number of shares: Issued – Treasury = Outstanding

Same

Valuation (g)

Vouch amount of paid-in capital to cash receipts.

(b)

Vouch amounts recorded for purchase to cash disbursements and amounts received on resale to cash receipts. Recalculate gain (loss) and trace to retained earnings or other capital account.

(c)

Read the financial statements, particularly the schedule of capital changes and the footnotes to determine whether the treasury stock amounts (including gains and losses) are properly classified and described.

GAAP disclosure

10.60

(h)

Read the financial statements and footnotes to determine whether all numbers of shares, terms, and descriptions are accurate.

(i)

Vouch stock option and profit-sharing plan disclosures to contracts and plan documents.

Stockholders’ Equity a.

(1)

The audit plan for the examination of Pate Corporation‘s Capital Stock account would include the following procedures: (a)

(Presentation and disclosure audit assertions.) Examine the articles of incorporation, the bylaws, and the minutes of the board of directors from the inception of the corporation to determine the provisions or decisions relating to the capital stock such as classes of stock, par value or stated value, authorized number of shares, authorization of the sale of new issues or additional sales of unissued stock, declarations of stock split ups and dividends in the form of cash or stock, and granting of stock options or stock rights.

(b)

(Existence and completeness audit assertions.) Examine the stock certificate stub book and determine whether the total of the open stubs agrees with the Capital Stock account in the general ledger. Examine canceled stock certificates that are generally attached to the corresponding stub. Information on the stubs regarding the number of shares, date, and so on for both outstanding and canceled stock certificates should be compared with the Capital Stock account. All certificate numbers should be accounted for.

(c)

(Valuation assertion.) Analyze the Capital Stock account from the corporation‘s inception and audit all entries. Trace all transactions involving the transfer of cash either to the cash receipts or the cash disbursements records. If property other than cash was received in exchange for capital stock, trace the recording of the property in the proper asset account and consider the reasonableness of the valuation placed on the property. If the analysis of the Capital Stock account discloses that the corporation has engaged in treasury stock transactions, determine that the increases or decreases in net assets resulting from these transactions have not been placed in the Retained Earnings account.

(2)

The audit procedures to be applied to the examination of the Capital Contributed in Excess of Par Value account are usually applied at the same time that the Capital Stock account is being examined because the two accounts are interrelated. The account should be analyzed and the entries audited when the related entries in the Capital Stock account are audited.

(3)

The following audit procedures would be applied to the Retained Earnings account: (a)

(Valuation assertion.) Analyze the account from its inception. Consider the validity of the amounts representing income or loss that were closed from the Profit and Loss account.

(b)

(Valuation assertion.) Any charges or credits made directly to the Retained Earnings account should be investigated and their treatment reviewed in relation to generally accepted accounting principles.

(c)

(Presentation and disclosure assertion.) Actions of the board of directors that affected retained earnings should be traced to the account analysis.

(d)

(Presentation and disclosure assertion.) Conditions, such as loan covenants or contingent liabilities, which were uncovered during the audit that might require or make desirable the placing of restrictions on retained earnings, should be brought to the client‘s attention, and provision should be made for proper disclosure in the financial statements.

(e)

(Valuation objective.) Entries recording cash or stock dividends should be traced to the minutes of the board of directors for authorization and to the Cash account or the Capital Stock account. A separate computation should be made by auditors of the total amount of dividends paid based upon their schedules of outstanding stock as an overall test of the reliability of the distributions. If stock dividends have been distributed, the amount removed from retained earnings should be reviewed for compliance with generally accepted accounting principles.

10.61

In conducting the audit, the auditors audit retained earnings as they do other items on the balance sheet for several reasons. A principal reason is that this part of the audit is an assurance or double check that no important item was overlooked in the examination of the accounts that were the contra or balancing part of the entry recorded in Retained Earnings. An example of an important item that may be overlooked would be a balance sheet account that was closed during the year under audit and the ledger card for the account removed from the general ledger current file. Another reason is that, although the entry in the contra account may have been examined, the auditors may have overlooked that the balancing part of the entry was to Retained Earnings, a treatment that may have been contrary to generally accepted accounting principles; their examination of retained earnings would bring this noncompliance to their attention.

Intercompany and Interpersonal Investment Relations This case is intended to evoke discussion of significant controlling interests in investments. a.

10.62

The issues revolve around (1)

Conflicts of interest. Students should recognize the apparent existence of non-arm‘slength transactions in the transfer prices of products to Hardy Hardware from Hardy Products. However, whether the prices are not equivalent to market prices is not certain. Hardy Hardware may outperform the rest of the industry for other reasons, and Hardy Products‘ net of 1 percent on sales may be characteristic of its business (although the 1 percent is extremely low). The brothers have no apparent conflict between themselves. Any conflict would have to be perceived as being between the brothers and the public shareholders.

(2)

The criterion presumption for using the equity method is a 20 percent stock ownership, and Hardy Hardware‘s ownership amounts to only 15 percent. However, other controlling influences are at work, namely, James Hardy‘s effective control of Hardy Hardware (20 percent) and his consequent ability to dictate the voting of the 15 percent interest in Hardy Products.

Some might say that this interrelationship of investments constitutes a significant controlling influence that, although not vested entirely in the investor corporation (Hardy Hardware), certainly operates to the benefit of Hardy Hardware. Whether to insist on the equity method in this case represents a difficult decision as the former auditor apparently found out.

The auditor should seek to compare the transfer prices to market-determined prices for the same or similar goods. The possibility exists that Hardy Products is charging break-even prices to that Hardy Hardware can show better operating results.

Adequate disclosure in this case is not an easy issue. Certain SEC rules require disclosure of transactions with controlling persons. Hardy Hardware will certainly have to observe SEC regulations in statements filed with the Commission, and the auditor might protect herself or himself as well as serve the public shareholders by insisting on similar disclosures in the annual report. The ―related-party transaction‖ disclosures specified in FASB statements and auditing standards would be appropriate.

Related-Party Transaction ―Goodwill‖

Audit Approach Objective: Obtain evidence of the valuation of assets given in exchange for stock and notes to find the proper valuation of recorded goodwill. 1-293 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Control: Control rests with the management and accounting estimates of the value of the assets given in exchange. Estimates of this type should be made with faithfulness to the underlying nature of the assets and their proper valuation. Tests of Controls: Auditors should determine the extent of management involvement in major investment and disposal transactions. Studying the minutes of the board and internal correspondence can help contribute this information. All other procedures bear directly on the substantive valuation evidence. Audit of balance: Because the Amron stock asset valuation was based on the transfer of the ammunition business assets to the new corporation, the underlying composition and book value of the assets should be determined in detail. This work should reveal that the Amron‘s stock carrying value included the deferred cost amount of $7 million. The hard part is discerning that the business purpose of the transactions is to get out of the sporting ammunition manufacturing business. If the auditors concentrate on the flow of the transaction and don‘t get the big picture, they might miss the event of discontinuance. The Big Industrial-Gulwest transaction appears to be clear. Gulwest received stock and a note with total value of $5.4 million. Piercing the veil of the intervening corporate creation transactions and transfers, Gulwest gave assets that were on its original books at $12.4 million. Discovery Summary The evidence of value received and cost given indicated a loss of $7 million. Auditors may need to be perceptive and a bit clever to identify it directly with the discontinued line of business, or even to call it ―discontinued.‖ Nevertheless, they were able to identify the amount as a loss and force its recognition in the Gulwest income statement. The spurious ―goodwill‖ was removed from the Gulwest balance sheet. 10.63

Related-Party Transaction Valuation Audit Approach Objective: Obtain evidence to determine the proper valuation of asset exchanges involving noncash property. Audit of balances: Upon knowing the date of the transaction purchasing the airplane from Wing and the number of Wing shares transferred, the auditors can look up the quoted market price in newspapers or other library sources for market price history. Finding the market price should determine the proper amount to record for the airplane. Auditors should have a list of all subsidiary companies and should be able to recognize the Mexican subsidiary as a related party. With this relationship, the amount of the transaction price is suspect. However, efforts can be made to obtain new and used airplane prices to determine whether the $3,750,000 price to the Mexican subsidiary bore any relation to observable airplane valuations. If the value were $3,750,000, the ―gain‖ exists in the transaction with the subsidiary, subject to elimination in consolidation. This ―gain,‖ if any, should not be offset against the loss from the exchange with Wing.

Discovery Summary The auditors were astute. They found that the market value of the Wing stock was $2,520,000 and insisted that the airplane be valued at $3 million instead of $3,750,000, thus making the loss on the exchange of Wing stock $750,000 larger. They also made sure that the subsequent gain on the sale to the Mexican subsidiary was eliminated in consolidation, awaiting any future profit confirmation by a sale to an outside party.

10.64

Lack of Controls over Investments AUDIT APPROACH Objective: To obtain evidence that trades recorded are valid and authorized (existence or occurrence assertion). Control: Several controls were missing at Baring Group. 

Leeson should have had a clear reporting line to a person of authority. Due to a reorganization, the two groups that might have had responsibility each thought he was reporting to the other one.



Long and short positions should always be balanced. Leeson could be unbalanced during the day but was supposed to be balanced at the end of each day.



Trading limits should have been strictly enforced. Because Leeson appeared to be profitable, trades of amounts over his limits were overlooked.



The Credit Control department should have approved ―loans to clients,‖ which Leeson used to hide losses.



Internal audit reports should be followed up on.



Reconciliations of funds remitted to trades made should have been completed and balanced daily.

Tests of controls: Auditors should:     

Obtain large trades and examine them for proper authorization. Examine reconciliations and Barings‘s follow up of unreconciled items. Ask for follow-up reports related to internal audit findings. Compare trades to authorization limits. Examine ―loans to clients‖ for credit authorization.

Audit of balances: The auditors should confirm the large balances in the ―loans to clients‖ account. They should also examine the details of account 88888 for authorization of transactions.

Discovery Summary In January 1995, The Singapore International Monetary Exchange (SIMEX) queried Baring on the size of their positions on the exchange. SIMEX specifically questioned irregularities in the margining of account 88888. Baring responded in a letter assuring SIMEX of the adequacy of funds to support the positions and made it clear that the entire assets of Baring Group were available to meet its financial obligations to SIMEX. Also in January 1995, Coopers & Lybrand, Singapore discovered a discrepancy of ¥7.7 billion between SIMEX and Baring accounts. Within a few days, six different versions of how the receivable had arisen were circulated among Baring senior management. On February 23, Leeson went missing. The liabilities he left behind totaled $1.3 billion—more than the entire capital and reserves of Baring. He was arrested in March in a German airport. On December 2, a Singapore court sentenced him to six and a half years. ―I don‘t think of myself as a criminal,‖ Leeson said before his trial.

CHAPTER 11 Completing the Audit LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

Identify major activities performed by auditors in completing the substantive procedures following the date of the financial statements.

1, 2, 3, 4, 5

31, 40, 41

Understand the role of attorney letters in evaluating litigation, claims, and assessments.

6, 7, 8

33, 43, 47, 50, 51

58, 59, 64, 67(*), 74, 75

Explain why auditors obtain written representations and list the key components of written representations.

9, 10, 11, 12

32, 45, 46

54, 55, 56, 57, 73(*)

Identify the final steps in the completion of an audit.

13, 14, 15, 16, 17, 18, 19, 20, 21

52, 53

60, 61, 62, 73(*)

Understand auditors‘ responsibility for subsequent events and subsequently discovered facts.

22, 23, 24, 25, 26, 27

34, 35, 36, 37, 42, 48, 49

63, 65(*), 66, 67(*), 68, 69, 70, 71(*), 73(*)

Identify important activities and communications following the completion of the audit and audit report release date.

28, 29, 30

38, 39, 44

65(*), 71, 72(*), 73(*)

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 11.1

The four primary periods in an audit examination and the tasks and activities that fall within each time period are: 1. Between the beginning of the year and date of the financial statements: interim tests of controls and substantive procedures. 2. Between the date of the financial statements and the date of the auditor‘s report: (1) completing substantive procedures, (2) obtaining attorneys‘ letters, (3) obtaining written representations, (4) making going-concern assessment, (5) evaluating the need for adjusting journal entries, (6) reviewing audit documentation, (7) identifying and evaluating subsequent events. 3. Between the date of the auditor‘s report and audit report release date: subsequently discovered facts. 4. Following the audit report release date: (1) subsequently discovered facts, (2) omitted audit procedures, (3) management letters, (4) communications with those charged with governance.

11.2

Roll-forward procedures are additional procedures performed by auditors to extend the conclusions from an interim date to the date of the financial statements. Common roll-forward procedures include examining material account transactions that occur between the interim testing date and the date of the financial statements.

11.3

Near the end of the audit, analytical procedures are used to (1) evaluate the adequacy of evidence gathered in response to unexpected account balance or relationships among account balances identified during the audit and (2) identify unusual or unexpected account balances or relationships among account balances that were not previously identified in earlier parts of the audit.

11.4

―Miscellaneous,‖ ―other,‖ and ―clearing‖ accounts may represent adjustments made by the client to meet analysts‘ earnings expectations (or earnings management).

11.5

Auditors are responsible for evaluating management‘s process for developing estimates as well as the overall reasonableness of management‘s estimates.

11.6

The responsibilities of client management are to (1) respond to auditors‘ inquiries regarding litigation, claims, and assessments, (2) provide auditors with a listing, description, and evaluation of litigation, claims, and assessments, and, (3) prepare letter to attorney (attorney letter) that includes information related to litigation, claims, and assessments.

The responsibilities of auditors are to (1) inquire of client regarding the existence of litigation, claims, and assessments, (2) perform various audit procedures regarding litigation, claims, and assessments, (3) initiate the request to the client for the attorney letter, and (4) mail attorney letter prepared by client.

The responsibility of the client‘s attorneys is to respond to auditors regarding the client‘s description of litigation, claims, and assessments.

11.7

11.8

11.9

Attorney letters ordinarily contain the following information: 

A list of pending or threatened litigation, claims, or assessments.



A description of each item, including the nature of the case and management responses or intended responses to the case.



An evaluation of the likelihood of an unfavorable outcome.



An estimate of the range of potential loss.

In addition to attorney letters, auditors would ordinarily perform the following with respect to litigation, claims, and assessments: 

Obtain from management a description of litigation, claims, and assessments.



Examine documents in the client‘s possession regarding litigation, claims, and assessments, including correspondence and invoices from attorneys.



Obtain assurance from management that it has disclosed all material unasserted claims of probable litigation about which the attorney has advised them.



Read minutes of meetings of stockholders, directors, and appropriate committees.



Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies.



Obtain information concerning guarantees from bank confirmations.



Review the legal expense account and cash disbursements records and invoices related to legal services.

The major categories of information contained in written representations are: 1.

The entity‘s financial statements, including: 

Management‘s responsibilities for the financial statements and internal control over financial reporting.



The appropriate disclosure, presentation, and reasonableness of certain items (accounting estimates, related parties, subsequent events, and litigation and claims).



A statement that uncorrected misstatements are immaterial to the financial statements taken as a whole.

Information provided to the auditors, both in general and related to sensitive areas (fraud, noncompliance with laws and regulations, litigation, and related-party transactions).

Internal control over financial reporting (for audits of public entities).

11.10

If the entity is subject to the requirements of AS 1305, auditors should obtain the following written representations related to internal control over financial reporting: 

Management has performed an assessment of the effectiveness of internal control over financial reporting based on established criteria (i.e., COSO criteria).



Management‘s conclusion with respect to the effectiveness of its internal control over financial reporting at year-end.



Management has disclosed all deficiencies in the design or operation of internal control over financial reporting, including separate disclosure of any deficiencies that it believes to be a significant deficiency or material weakness.



There are no subsequent changes in internal control over financial reporting or other factors that may significantly affect internal control over financial reporting.

11.11

These communications are obtained near the end of fieldwork and dated on or near the date of the auditor‘s report to ensure that the most current information has been considered and evaluated by auditors. (Written representations must be dated on the date of the auditor‘s report).

11.12

If the client refuses to furnish written representations, auditors may either qualify or disclaim an opinion as with other scope limitations. However, because of the importance of this communication, auditors should be very skeptical if the client refuses to furnish written representations.

11.13

Auditors are required to consider whether any evidence that comes to their attention during the audit examination provides substantial doubt about the client‘s ability to continue as a going concern for a period not to exceed one year beyond the date of the financial statements being audited.

11.14

Factors that may indicate that substantial doubt exists about the client‘s ability to continue as a going concern include:

11.15



Negative trends, such as recurring operating losses, working capital deficiencies, and negative cash flow from operations.



Signals of financial difficulties, such as default on loans, denial of trade credit from suppliers, restructuring of debts, or arrearages in dividends.



Internal matters such as work stoppages or substantial dependence on the success of a particular project or activity.



External matters, such as legal proceedings; loss of a key franchise, license, or patent; or loss of a major customer or supplier.

If evidence suggests that substantial doubt exists about the client‘s ability to continue as a going concern, auditors should obtain information about management‘s plans to mitigate the effect of these factors and assess the likelihood that these plans can be effectively implemented. If after evaluating this evidence, auditors believe that substantial doubt continues to exist about the client‘s ability to continue as a going concern, auditors should ensure that appropriate disclosures are provided in the financial statements and issue an unmodified opinion with a separate section in the report with the heading Substantial Doubt About the Entity's Ability to Continue as a Going Concern. On the other hand, if auditors conclude that the risk of going-concern uncertainties is low, no disclosures or report modifications are necessary.

11.16

Adjusting entries and note disclosures are labeled ―proposed‖ because it is ultimately the client‘s responsibility to adjust the financial statements for these items.

11.17

An uncorrected misstatement is a misstatement that the auditor has identified and accumulated during the audit that has not been corrected (or adjusted) by the client. Auditors are required to communicate all uncorrected misstatements detected during the audit to individuals charged with governance (such as the client‘s audit committee), regardless of the materiality of these misstatements to the client‘s financial statements. Often, management decides not to make all of the proposed corrections because of materiality or cost-benefit considerations.

11.18

The rollover method considers only the current-period income effect(s) of any misstatements. In contrast, the iron curtain method considers the aggregate effect of the misstatements on the entity‘s balance sheet. Staff Accounting Bulletin No. 108 requires auditors to evaluate misstatements using both methods and propose an adjustment if either method indicates that the misstatement exceeds the level of performance materiality.

11.19

Upon completion, the audit documentation is reviewed by an audit supervisor and, sometimes, audit manager. The purpose of this review is to ensure that all appropriate steps in the audit program were performed, the referencing among audit documentation is clear, and the explanations contained in the audit documentation are understandable.

Once this initial review has been completed, the audit manager and audit partner review the audit documentation to ensure that the overall scope of the audit is appropriate and determine whether the overall conclusions in the audit documentation are sufficient to provide support for the opinion on the financial statements.

Finally, the audit documentation is reviewed by a partner who has not been involved with the audit (known as a reviewing partner). The purpose of this review is to ensure that the quality of audit work and reporting is consistent with the firm‘s quality standards.

11.20

An engagement quality review is a review of audit documentation by a partner (or equivalent with the firm) who is not involved with the audit. The purpose of this review is to ensure that the quality of the work and reporting is in keeping with the quality standards of the firm and that the evidence obtained during the audit is sufficient to support the opinion on the client‘s financial statements.

11.21

Some of the benefits of audit documentation review are:

11.22



To ensure the audit is conducted in accordance with GAAS.



To provide the firm an opportunity to evaluate the overall quality of the firm‘s audit practice.



To provide an important component of the training and evaluation of audit staff members.



To allow the firm to adhere to the performance principle, which requires that auditors adequately plan the work and properly supervise any assistants.

A subsequent event is an event occurring between the date of the financial statements and the date of the auditor‘s report.

11.23

11.24

Procedures performed to identify subsequent events include: 

Obtaining an understanding of the procedures performed by management to identify subsequent events.



Inquiring of management and those charged with governance as to the existence of subsequent events (and then corroborate this inquiry through written representations).



Reading minutes of meetings of owners, management, or those charged with governance held after the date of the financial statements.



Reviewing the entity‘s latest interim financial statements (if applicable).

The two types of subsequent events are: 

Events that provided additional evidence of conditions that existed at the date of the financial statements. These subsequent events typically require adjustment to the financial statements to reflect the new information.



Events that provide evidence of conditions that arose following the date of the financial statements. These subsequent events require disclosure of the information in the financial statements or footnotes accompanying the financial statements.

11.25

Subsequently discovered facts are facts that become known to auditors after the date of the auditor‘s report that, if known by the auditor, could have caused the auditor to revise the auditor‘s report.

11.26

If subsequently discovered facts are identified prior to the audit report release date, auditors can evaluate the appropriateness of the disclosure of these events and dual date their report.

If subsequently discovered facts are identified following the audit report release date, auditors should first assess whether (1) these facts would require revision of their report or the financial statements or (2) individuals are continuing to rely on the financial statements, If so, auditors should ensure that clients notify individuals known to be relying on the financial statements of the subsequently discovered facts and issue revised financial statements as soon as possible.

11.27

Dual dating the auditor‘s report provides a means of inserting important information in the financial statements and footnote disclosures learned by auditors after the date of the auditor‘s report. A significant advantage of dual dating the report is that auditors‘ liability for events after the date of the auditor‘s report is limited to the event specifically identified in the report date.

11.28

If an omitted procedure is discovered, the following courses of action would be taken: 1. Verify that (a) the omitted procedure is important in supporting the auditors‘ opinion and (b) individuals are currently relying on the client‘s financial statements and reports. 2. If both of the above conditions exist, auditors should perform the omitted procedure or alternative procedures, if practicable. If both do not exist, no further action is necessary. 3. If performing the omitted or alternative procedures allows auditors to support the previously expressed opinion, no further action is necessary. However, if it does not, auditors should formally withdraw the original reports, issue revised reports, and inform persons currently relying on the financial statements.

11.29

Auditors should communicate the following information to individuals charged with governance:           

11.30

Auditors‘ responsibility under generally accepted auditing standards. An overview of the planned scope and timing of the audit. Auditors‘ judgment about the quality of the client‘s accounting policies, accounting estimates, and financial statement disclosures. Any significant difficulties encountered during the audit. Any uncorrected misstatements, other than those auditors believe to be trivial. Any disagreements with management. Material, corrected misstatements that were brought to the attention of management. Representations requested from the client‘s management. Any management consultations with other auditors. Any significant issues arising from the audit that were discussed with management. Other findings or issues that are significant and relevant to those charged with governance.

A management letter contains a summary of recommendations to allow the client to improve the effectiveness and efficiency of its operations. They are not required by generally accepted auditing standards.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 11.31

11.32

11.33

Incorrect

Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

Analytical procedures are not related to the auditors‘ involvement with internal control over financial reporting or identifying deficiencies in internal control over financial reporting. Identifying accounts that appear to be misstated with the intention of planning the nature, timing, and extent of substantive procedures is the purpose of performing analytical procedures during the planning of the audit. Gathering evidence to support assertions is the purpose of performing analytical procedures during substantive testing. Performing analytical procedures near the end of the audit provides the auditors an overall review of the financial statements and allows auditors to assess the adequacy of evidence gathered during the audit. Written representations do not shift responsibility to auditors for the financial statements. Written representations should not substitute for other evidence sources. Management makes assertions directly in the financial statements, not as part of the written representations. This responsibility is explicitly included in the written representations.

NOTE TO INSTRUCTOR: Because this question asks students to identify which audit procedure is not used to obtain evidence about contingencies, the response labeled “correct” is not used to obtain evidence about contingencies and those labeled “incorrect” are used to obtain evidence about contingencies. a. b. c.

Correct Incorrect Incorrect

Incorrect

Scanning expenses is unlikely to reveal any information about a contingency. Attorney letters can provide information about contingencies. Minutes of board of directors‘ meetings can provide information about contingencies. Sales contracts can provide information about right of return that may need to be disclosed as a contingency.

11.34

11.35

11.36

11.37

11.38

a. b. c.

Incorrect Incorrect Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

b. c.

Correct Incorrect

Incorrect

b. c.

Incorrect Correct

Incorrect

The issuance of stock occurred after December 31. An injury related to the lawsuit was sustained after December 31. Because an estimate had been made as of December 31, the event giving rise to the lawsuit had occurred, and the settlement introduced new information about the actual amount of the liability at December 31. The storm occurred after December 31. The report date is the audit completion date, not the date of the financial statements. In addition, the second date should be the date related to the specific event. The report date is the audit completion date and the dual date is the date related to the specific event. While the second date is correct, the report date is the audit completion date, not the date of the financial statements. The report date is the audit completion date, not the date of the subsequent event. Auditors are responsible for ensuring that management discloses new information related to subsequent events that occur following the date of the financial statements but prior to the audit report release date. Because auditors have not yet released their reports, the responsibility for information related to subsequent events exists until the audit report release date. This response would be correct if the subsequent events were discovered following the audit report release date. Auditors are responsible for ensuring that management properly discloses all information related to subsequent events that are known prior to the audit report release date. Once the auditor‘s report has been released, any new information regarding subsequent events would not affect the current audit. Subsequently discovered facts are identified after the date of the auditor‘s report. Assuming that events identified after the beginning of fieldwork are identified prior to the date of the auditor‘s report, they are not subsequently discovered facts. Subsequently discovered facts are identified after the date of the auditor‘s report. These types of events are referred to as subsequent events. Subsequently discovered facts are identified after the date of the auditor‘s report. These types of events do not require any special audit consideration. Subsequently discovered facts are identified after the date of the auditor‘s report. Written representations are required under generally accepted auditing standards. Attorney letters are required under generally accepted auditing standards. Management letters, while helpful, are not required under generally accepted auditing standards. Engagement letters are required under generally accepted auditing standards.

11.39 NOTE TO INSTRUCTOR: Because this question asks students to identify which party would not participate in writing the management letter, the response labeled “correct” would not participate in writing the management letter and those labeled “incorrect” would participate in writing the management letter.

11.40

11.41

11.42

11.43

Correct

Incorrect

Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

The client‘s attorneys would not ordinarily participate in drafting the management letter because this letter concerns helpful suggestions to increase the effectiveness and efficiency of the client‘s operations. The client‘s accounting and production managers would provide information about current practices for the management letter. The accounting firm‘s team would play a major role in drafting the management letter based on their observations during the audit examination. The accounting firm‘s consulting and tax experts would participate in drafting the management letter because they are in a position to identify possible efficiencies and income tax savings. An engagement letter would be secured prior to the commencement of the audit examination. Tests of controls would be performed prior to the date of the financial statements. A review for subsequent events would be performed after year-end but prior to the date of the auditor‘s report. Written representations would be obtained on the date of the auditor‘s report. Discovery of an omitted audit procedure occurs after the audit report release date. Dual dating the auditor‘s report occurs following the date of the auditor‘s report. The management letter is prepared and presented to the client following the conclusion of the audit examination. The review of audit documentation occurs after the date of the financial statements but before the date of the auditor‘s report.

NOTE TO INSTRUCTOR: Because this question asks students to identify the item for which Ambrose would have the least responsibility, the response labeled “correct” is the item for which he would have least responsibility and those labeled “incorrect” are items for which he would have most responsibility. a.

Incorrect

Correct

Incorrect

Correct

Ambrose would have responsibility for this event because it occurred prior to the date of his report. This matter was identified following the date of Ambrose‘s report but prior to the release of Ambrose‘s report. This is an example of a subsequently discovered fact. While this event occurred after the date of the financial statements, it was identified prior to the date of Ambrose‘s report. This is an example of a subsequent event and should be evaluated by Ambrose prior to the release of his report. Because this event occurred following the release of Ambrose‘s report, he would not have responsibility for this event because it relates to the 2018 audit. This statement would typically be included in written representations but not an attorney letter. While this statement is related to communication with attorneys, it would not be appropriate for the attorney to directly inform auditors of omitted unasserted claims or assessments. This statement would ordinarily be included in a management letter, not an attorney letter. The attorney letter would request that the attorney furnish this information to auditors.

11.44

11.45

11.46

11.47

11.48

Incorrect

Correct

Incorrect

Prior to performing the omitted procedure or an alternative procedure, auditors would determine that the omitted procedure is important in supporting the opinion on the entity‘s financial statements. Prior to notifying the board of directors and regulatory agencies who are currently relying on the auditor‘s reports, auditors would determine that the omitted procedure is important in supporting the opinion on the entity‘s financial statements. This is the initial course of action that would be taken upon the discovery of an omitted audit procedure. A quality assurance review may reveal the omission of an audit procedure but would not be performed in response to an omitted procedure.

NOTE TO INSTRUCTOR: Because this question asks students to identify which statement is not true with respect to written representations, the response labeled “correct” would not be true and those labeled “incorrect” would be true. a.

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

The failure of management to furnish representations would result in either a qualified opinion (not an adverse opinion) or a disclaimer of opinion. Written representations do address management‘s responsibility to design internal control to prevent and detect fraud. Written representations are used by auditors to corroborate information received from the client and its employees. Written representations are dated the same date as the auditor‘s reports (the audit completion date). Written representations are dated as of the date of the auditor‘s report (in this case, March 24, Year 2), not the date of completion of the financial statements. Written representations are dated as of the date of the auditor‘s report (in this case, March 24, Year 2), not the date that fieldwork began. Written representations are dated as of the date of the auditor‘s report (in this case, March 24, Year 2). Written representations are dated as of the date of the auditor‘s report (in this case, March 24, Year 2), not the audit report release date. Examining legal invoices provides assurance that attorneys‘ letters have been sent to all attorney‘s that have performed substantive work for the company. An attorney‘s letter is the primary method used to corroborate information on litigation, claims, and assessments. An auditor does not have the legal training to assess attorney-client privilege. An attorney‘s letter is the primary method used to corroborate information on litigation, claims, and assessments. While a management representation letter asks whether management has provided all information regarding litigation, claims and assessments, an attorney‘s letter is the primary method used to corroborate information on litigation, claims, and assessments. Comparing interim financial statements with the financial statements being audited would identify potential subsequent events. Second request confirmations would provide evidence regarding the valuation of accounts receivable balances but would not provide evidence regarding subsequent events. Communicating material weaknesses in internal control would provide the client the opportunity to improve its internal control but would not provide evidence regarding subsequent events. Reviewing the cutoff bank statement would verify the valuation of cash but would not provide evidence regarding subsequent events.

11.49

11.50

11.51

11.52

11.53

Incorrect

Correct

Incorrect

Correct

c. d.

Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

a. b. c. d.

Incorrect Incorrect Incorrect Correct

This procedure would provide evidence about the valuation of these transactions but not subsequent events. This procedure may provide information about sales and repurchases of the entity‘s stock. This procedure would be used to search for unrecorded accounts payable at year-end but not the occurrence of subsequent events. This procedure would provide evidence about the valuation of cash and potential guarantees of debt but not subsequent events. While the attorney letter will ask for corroboration of management‘s information regarding the probable outcome of litigation, claims, and assessments, management is the primary source of this information. The attorney letter requests the attorneys to corroborate information furnished from management. Historical experiences are not included in an attorney letter. A description and evaluation of litigation, claims, and assessments is obtained from the client; the attorney is asked to corroborate this information; see (b). The attorneys‘ response should be limited to matters to which they have given substantive attention. The attorneys should comment on matters of which they are aware that were not disclosed by the entity. The attorney should not limit his or her response to matters in which the entity has historical experience. The attorney should also comment upon unasserted claims as well as asserted claims and pending or threatened litigation. Auditor‘s do have a responsibility to evaluate whether there is substantial doubt for an entity to continue as a going concern for a reasonable period of time. When auditor‘s suspect there is doubt that an entity will continue as a going concern, they must obtain and discuss with management their plan to continue as a going concern. Auditor‘s may decide to do this after they have evaluated management‘s plan to continue as a going concern and determined that substantial doubt still remains that the entity will continue as a going concern. The auditor would not resign from the engagement. The auditor should document this, as well as b and c. The auditor should document this, as well as a and c. The auditor should document this, as well as a and b. The auditor should document the conditions or events that suggest a going concern uncertainty, management‘s plan (or lack of) to mitigate the conditions and to continue as a going concern, and the auditor‘s conclusion on whether substantial doubt still exists and whether a report modification is needed.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 11.54

Written Representations a.

Auditors are required to obtain written representations in all audits conducted under generally accepted auditing standards.

The major categories of information contained in written representations are: 1.

The entity‘s financial statements, including: 

Management‘s responsibilities for the financial statements and internal control over financial reporting.



The appropriate disclosure, presentation, and reasonableness of certain items (accounting estimates, related parties, subsequent events, and litigation and claims).



A statement that uncorrected misstatements are immaterial to the financial statements taken as a whole.

Information provided to the auditors, both in general and related to sensitive areas (fraud, noncompliance with laws and regulations, litigation, and related-party transactions).

Internal control over financial reporting (for audits of public entities).

Written representations should be addressed to auditors and dated as of the date of the auditor‘s reports (audit completion date).

Written representations should be signed by members of management whom auditors believe are responsible and knowledgeable about matters covered by the representations (usually the chief executive officer, chief financial officer, treasurer, or controller). Their refusal to sign the representations would constitute a scope limitation that would preclude the issuance of an unqualified opinion.

Obtaining written representations does not relieve auditors from their responsibility for planning and performing the audit. As a result, auditors must still perform all usual procedures to corroborate representations made by management.

11.55

Written Representations Omissions The items presented in Molar‘s written representations are appropriate and would serve to confirm various matters that have been identified during the audit. However, in addition to these items, the following items related to the management‘s responsibilities and information provided to auditors should be included in Molar‘s representations: 1.

Matters related to the financial statements, such as: 

Management‘s responsibility for the preparation and fair presentation of the financial statements in accordance with U.S. GAAP.



Management‘s acknowledgement of its responsibility to design, implement, and maintain internal control to ensure that financial statements are free of material misstatement whether due to fraud or error.



Management‘s acknowledgment of its responsibility to design, implement, and maintain internal control to prevent or detect fraud.



The reasonableness and proper accounting of various items and transactions (accounting estimates, related-party transactions, etc.).



Management‘s acknowledgement that they have provided auditors access to all information relevant to the presentation and preparation of the financial statements.

Matters related to information provided to auditors, including: 

Access to all information related to the preparation and presentation of the financial statements (including additional information requested by Dweebins).



Access to persons within Amis Manufacturing.



All transactions have been recorded in the accounting records and are reflected in the financial statements.



Disclosure of the results of Amis‘s assessment of the risk that the financial statements may be materially misstated as a result of fraud.



Specific acknowledgement related to audit-sensitive areas (fraud, related-party transactions).

11.56

Written Representations a.

Appropriate.

Inappropriate. While written representations address fraud involving management and employees who have significant roles in internal control, they do not indicate that no frauds that could have a material effect exist. Management‘s assessment of internal control over financial reporting will not provide management a basis for a statement of this nature. A more appropriate statement would be ―we have no knowledge of any fraud.…‖

Appropriate.

Inappropriate. The description and evaluation of contingencies would accompany the letter sent to the client‘s attorney. While written representations indicate that management is unaware of unasserted claims or assessments that are required to be disclosed in accordance with Accounting Standards Codification 450, they would not list contingencies in which attorneys have participated.

Inappropriate. While written representations will indicate that all deficiencies in the design or operation of internal control have been disclosed to auditors, they will not state that no such deficiencies exist even in cases for which no deficiencies are noted.

Inappropriate. Management letter comments are merely advisory to management, and no action is required to be taken on these comments. Accordingly, reference to action on previous management letter comments is not appropriate.

Inappropriate. Management‘s assessment of internal control over financial reporting will not provide such a high level of assurance to management; as a result, a reference of this nature in written representations is not appropriate. A more appropriate statement would be that ―we have maintained an effective internal control over financial reporting.‖

Appropriate.

11.57

Written Representations a.

Included in written representations in all audits.

Not included in written representations. (This would accompany an attorney letter sent from the client to its attorneys.)

Not included in written representations. (This would be included in a management letter prepared by auditors to the client.)

Included in written representations in all audits.

Included in written representations in audits of public entities.

Included in written representations in all audits.

Not included in written representations. (This would be communicated to the client‘s audit committee or those charged with governance.)

Included in written representations in audits of public entities.

Not included in written representations. (Written representations indicate that management believes the effects of uncorrected misstatements are immaterial to the financial statements and that management has fulfilled its responsibility for the preparation and presentation of financial statements according to GAAP. However, written representations should not express an opinion on the financial statements.)

11.58

Client Request for Attorney Letter NOTE TO INSTRUCTOR: The categories of “Major” and “Other” deficiencies are the authors’ judgment. Students should be able to identify the “Major” deficiencies, while the “Other” deficiencies may be a bit more difficult to identify. MAJOR DEFICIENCIES 1.A description of the progress of each case to date is omitted. 2.

An evaluation of the likelihood of an unfavorable outcome of each case is omitted.

An estimate, if one can be made, of the amount or range of potential loss of each case is omitted.

The various other pending or threatened litigation on which Young was consulted is not identified and included.

The unasserted claims and assessments probable of assertion that have a reasonable possibility of an unfavorable outcome are not identified.

Materiality (or the limits of materiality) is not addressed.

The reference to a limitation on Young‘s response due to confidentiality is inappropriate.

Young is not requested to include matters that existed after December 31, 2012, up to the date of Young‘s response.

There is no inquiry about any unpaid or unbilled charges, services, and disbursements.

OTHER DEFICIENCIES 10.

The action that Consolidated intends to take concerning each suit (for example, to contest the matter vigorously, to seek an out-of-court settlement, or to appeal an adverse decision) is omitted.

11.

Consolidated‘s understanding of Young‘s responsibility to advise Consolidated concerning the disclosure of unasserted possible claims or assessments is omitted.

12.

Young is not requested to identify the nature of and reasons for any limited response.

13.

The date by which Young‘s response is needed is not indicated.

14.

The reference to Young‘s response possibly being quoted or referred to in the financial statements is inappropriate.

15.

Ambiguous terminology such as ―slight‖ and ―some chance‖ is included when ―remote‖ and ―possible‖ are more appropriate.

11.59

Attorney Letters a.



Inquire of management regarding litigation, claims, and assessments.



Obtain from management a description and evaluation of litigation, claims, and assessments.



Examine documents in the client‘s possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers.



Obtain assurance from management that it has disclosed all material unasserted claims the lawyer has advised them are likely to be litigated.



Read minutes of meetings of stockholders, directors, and appropriate committees.



Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies.



Obtain information concerning guarantees from bank confirmations.



Review the legal expense account and cash disbursements records and invoices related to legal services.

Jaworski‘s responsibilities with respect to litigation, claims, and assessments are to perform the procedures noted in (a) and initiate the request to the client for the attorney letter. Fulbright‘s responsibilities with respect to litigation, claims, and assessments are to respond to auditors‘ inquiries regarding litigation, claims, and assessments; provide auditors a list, description, and evaluation of litigation, claims, and assessments; and send a letter to the attorney that includes information related to litigation, claims, and assessments. Vinson‘s responsibilities with respect to litigation, claims, and assessments are to respond to auditors regarding Fulbright‘s description of litigation, claims, and assessments.

•

Auditors initiate the request for the client to send the attorney letter.



The attorney letter, along with a list of litigation, claims, and assessments, is sent to each attorney who has devoted attention to legal matters on behalf of the client.



The attorneys will respond directly to auditors on the information contained in the attorney letter.

The following information is typically included in an attorney letter (prepared from the client‘s perspective): 

A list of pending or threatened litigation, claims, or assessments.



A description of each item, including the nature of the case and management responses or intended responses to the case.



An evaluation of the likelihood of an unfavorable outcome.



An estimate of the range of potential loss.

11.60

Uncorrected Misstatements and Performance Materiality a.

The misstatement would have the following financial statement effects:    

Overstatement of net income by $8,690 (assume taxes of $2,310). Overstatement of assets by $11,000. Overstatement of liabilities by $2,310 (taxes payable). Overstatement of equity by $8,690.

Turner‘s comment is incorrect. While this misstatement is not material by itself, it might result in material misstatements when considered along with previously identified (but not corrected) misstatements.

The rollover method considers only the current-period income effect(s) of a misstatement when evaluating its materiality; the iron curtain method considers the aggregate balance sheet effects of the current misstatement along with previously identified misstatements when evaluating materiality.

Under the iron curtain method, Rivers would consider both the current misstatement as well as the previous misstatements. Summarizing the misstatements from 2015–2019 reveals an uncorrected misstatement (net balance sheet effect) from prior audits of $18,450; including the current misstatement of $8,690 would result in a cumulative effect of $27,140. Under the rollover method, Rivers would only consider the amount of the current period misstatement ($8,690) in evaluating performance materiality.

Under the iron curtain method, because the cumulative effect noted in (d) of $27,140 exceeds the materiality level of $25,000, Rivers should propose an adjustment to Chargers‘ financial statements. Ordinarily, Rivers would recommend an adjustment of the entire $27,140 of uncorrected misstatements (assuming that these misstatements were actual misstatements, not projections of identified misstatements). If a projection of identified misstatements, the minimum adjustment would be $2,141, which would result in an adjusted cumulative effect of $24,999 ($27,140 – $2,141 = $24,999), which is less than performance materiality. Under the rollover method, because the amount of the misstatement ($8,690) is less than the materiality level ($25,000), Rivers would not require an adjustment to the financial statements.

11.61

Uncorrected Misstatements and Performance Materiality a.

An uncorrected misstatement is a misstatement that the auditor has identified during that audit that has not been corrected (or adjusted) by the client. Auditors are responsible for accumulating uncorrected misstatements and determining whether these misstatements have a material effect on the client‘s financial statements. If these misstatements have a material effect on the client‘s financial statements, auditors should propose an adjustment to the client‘s financial statements.

When using the rollover method, auditors consider only the current-period income effects of a misstatement when evaluating its materiality. When using the iron curtain method, auditors consider the aggregate balance sheet effects of the current misstatement along with previously identified misstatements when evaluating materiality.

Under the rollover method, auditors would conclude that the misstatements were not material because the current-period effects of the misstatements ($100,000) are less than the materiality level ($150,000). Under the iron curtain method, auditors would consider both the current-period effects of the misstatement as well as the cumulative effect of prior unrecorded misstatements. As a result, the aggregate misstatement would be $220,000 ($100,000 of current misstatements + $120,000 of prior uncorrected misstatements). This aggregate misstatement exceeds materiality of $150,000.

Because the auditors would conclude that the misstatements were not material under the rollover method, no adjusting entry would be necessary. While the auditors could recommend that the client adjust its financial statements for all known misstatements, the failure of clients to prepare these adjustments would not affect the fairness of the financial statements because the currentperiod uncorrected misstatements are less than the materiality level. Under the iron curtain method, the auditors would conclude that the aggregate misstatement is material. As a result, they should propose an adjustment to the financial statements. Ordinarily, auditors would recommend an adjustment of the entire $220,000 of uncorrected misstatements (assuming that these misstatements were actual misstatements, not projections of identified misstatements). If it is a projection of identified misstatements, the minimum adjustment would be $70,001, which would result in an adjusted cumulative effect of $149,999 ($220,000 – $70,001 = $149,999), which is less than materiality.

Auditors are required to communicate all misstatements identified during the audit to the client‘s audit committee (or other individuals charged with governance). These should be communicated regardless of whether they have a material effect on the financial statements.

11.62

Uncorrected Misstatements and Performance Materiality a.

The misstatement would have the following financial statement effects: 

Overstatement of income by $102,700 (assume taxes of $27,300).



Understatement of liabilities by $102,700 (understatement of accrued payables by $130,000, overstatement of taxes payable by $27,300).



Overstatement of equity by $102,700.

Under the rollover method of evaluating misstatements, Colt would consider only the currentperiod income effects of a misstatement when evaluating its materiality. As a result, Colt would conclude that the misstatement was not material because the amount of the misstatement ($102,700) was less than the materiality level ($180,000).

Under the iron curtain method of evaluating misstatements, Colt would consider the aggregate balance sheet effects of the current misstatement along with the effect of prior uncorrected misstatements when evaluating materiality. Summarizing the misstatements from 2011-2013 reveals an uncorrected misstatement (net balance sheet effect) from prior audits of $74,500 ($82,500 + $22,000 – $30,000). Including the current misstatement of $102,700 would result in a cumulative effect of $177,200, which is less than the materiality level of $180,000. This cumulative effect would be carried forward for consideration in future audits.

Under the rollover method, because the current misstatement ($102,700) is more than the materiality level of $100,000, Colt would conclude that the misstatement is material. Under the iron curtain method, the aggregate misstatement of $177,200—see (c)—exceeds the materiality level of $100,000. As a result, Colt would conclude that the misstatement is material.

If Colt concluded that the misstatements were material, it should propose an adjustment to the financial statements. Ordinarily, Colt would recommend an adjustment of the entire $102,700 (rollover method) or $177,200 (aggregate method) of uncorrected misstatements (assuming that these misstatements were actual misstatements, not projections of identified misstatements). The minimum adjustment would be $2,107 for the rollover method and $77,201 for the aggregate method, which would result in an adjusted effect of $99,999.

11.63

11.64

Subsequent Events—Internet Exercise a.

A subsequent event is an event occurring between the date of the financial statements and the date of the auditor‘s report.

Dole‘s fiscal year-end is January 2, 2010.

The date of Deloitte & Touche‘s report is March 25, 2010.

Dole‘s 10-K was filed with the SEC on March 25, 2010 (this is the Filing Date column on the SEC webpage).

Yes, it does because the event occurred on February 27, 2010, and appears to have been known by auditors prior to the date of their report (March 25, 2010).

This would be an event that arose after the date of the financial statements.

Dole‘s auditors would likely verify that the event did, in fact, occur. Because no estimate of the impact on Dole‘s financial statements can be made at this time, Deloitte & Touche cannot evaluate whether such estimates are reasonable.

Attorney Letters and Litigation—Internet Exercise NOTE TO INSTRUCTOR: Responses to parts (a) and (d) will depend on the disclosure identified by the student. One interesting method of debriefing this exercise is to ask one student to share his or her example of litigation with the class and determine whether other student(s) with a similar type of litigation examples identified similar audit procedures and approaches. With respect to (b) and (c), the following are applicable to various types of litigation examples. a.

See the Note to Instructor.

The auditors‘ primary concern with respect to the disclosure of pending litigation is that all items are properly presented and disclosed in the client‘s financial statements.

The responsibilities of these various parties are:

Entity

 Respond to auditors‘ inquiries regarding pending litigation.  Provide auditors a list, description, and evaluation of pending litigation.  Send letter to attorneys that includes information related to litigation.

Auditors

 Inquire of entity regarding existence of pending litigation.  Perform various procedures regarding pending litigation.  If risk of material misstatement is assessed for pending litigation, initiate request to entity for attorney letter.

Attorney

 Respond to auditors regarding entity‘s description of pending litigation.

See Note to Instructor.

11.65

Omitted Procedures and Subsequently Discovered Facts—Internet Exercise Assuming that the facts would require revision of the financial statements or auditor‘s report and that individuals are currently relaying on the client‘s financial statements, auditors would request that the client:

1. Notify individuals known to be relying on the financial statements or likely to rely on the financial statements that (1) the financial statement should not be relied upon and (2) revised financial statements and a new auditor‘s report will be issued. 2. Issue revised financial statements with appropriate disclosure of the matter related to the subsequently discovered facts as soon as practicable. The auditors‘ responsibility for omitted procedures is to perform the omitted procedures or alternative procedures if (1) the procedures are important in supporting the auditors‘ opinion and (2) individuals are currently relying on the client‘s financial statements and auditor‘s reports. The students‘ response to this question will depend on which years‘ reports are reviewed. Three general responses that are provided by firms are (1) that they disagree with the PCAOB review report‘s assessment, (2) that they believe that any subsequently discovered facts or omitted procedures did not affect their opinion on the client‘s financial statements; and, (3) that they performed either the omitted procedure or a similar procedure. One important point to raise as you review this part of the exercise is that even major accounting firms can encounter issues related to omitted procedures and subsequently discovered facts.

11.66

Subsequent Events and Subsequently Discovered Facts a.

A subsequent event is an event or transaction that occurs after the date of the financial statements but prior to the date of the auditor‘s report. Therefore, Michael Ewing is responsible for subsequent events occurring up to the date of the auditor‘s report.

Procedures that Michael can perform to assist him in identifying subsequent events include:



Obtaining an understanding of the procedures performed by management to identify subsequent events.



Inquiring of management and those charged with governance as to the existence of subsequent events (and subsequently corroborate this inquiry through written representations).



Reading minutes of meetings of owners, management, or those charged with governance held after the date of the financial statements.



Reviewing the entity‘s latest interim financial statements (if applicable).

The two types of subsequent events are: 

Events that provide additional evidence about conditions that existed at the date of the financial statements. Because the condition existed at the date of the financial statements, this type of subsequent event requires adjustment of amounts included in the financial statements.



Events that provide evidence of conditions that arose following the date of the financial statements. These events should be disclosed in the financial statements. Michael should proceed as follows:



He could evaluate the disclosure of this event without additional considerations because he became aware of the transaction prior to the date of the auditor‘s report.



This is an example of a subsequently discovered fact. In this situation, Michael could evaluate the disclosure of this event because his reports (and the financial statements) have not been issued. However, because he became aware of the subsequent event following the date of the auditor‘s report, he would ordinarily dual date the auditor‘s report to limit his responsibility beyond the date of the auditor‘s report to the disclosure related to the subsequent event.



This is an example of a subsequently discovered fact. In this situation, Michael became aware of the transaction after the audit report release date. Assuming that these facts affect the financial statements or Michael‘s report and persons are continuing to rely on the financial statements, Michael should request that Dallas Company‘s management disclose the facts, their impact on the financial statements, and issue revised financial statements. Because the announced acquisition of San Antonio Company did not exist at the date of Michael‘s report, Michael has no responsibility with respect to this acquisition in the 2020 audit.

11.67

Subsequent Events and Contingent Liabilities a.

A subsequent event is an event or transaction that occurs after the date of the financial statements but prior to the date of the auditor‘s report.

The two types of subsequent events are:  Events that provide additional evidence about conditions that existed at the date of the financial statements. Because the condition existed at the date of the financial statements, this type of subsequent event requires adjustment of amounts included in the financial statements.  Events that provide evidence of conditions that arose following the date of the financial statements. These events should be disclosed in the financial statements.

Procedures performed to ascertain the occurrence of subsequent events include:  Obtaining an understanding of the procedures performed by management to identify subsequent events.  Inquiring of management and those charged with governance as to the existence of subsequent events (and subsequently corroborate this inquiry through written representations).  Reading minutes of meetings of owners, management, or those charged with governance held after the date of the financial statements.  Reviewing the entity‘s latest interim financial statements (if applicable).

A contingent liability is an existing condition, situation, or set of circumstances involving uncertainty as to a possible loss that will ultimately be resolved when one or more future events occur or fail to occur.

A contingent liability should be accrued only if information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. A contingent liability should be disclosed in a note when it is probable that a liability has been incurred but the amount cannot be estimated. A contingent liability for which it is only reasonably possible that a liability has been incurred should be disclosed in a note. When the probability that a liability has been incurred is remote, no disclosure is required.

Subsequent events may provide new and important information about known or unknown loss contingencies as of the date of the financial statements. The subsequent event may very well modify the circumstances surrounding the contingent loss, thereby changing the reporting method from no disclosure to note disclosure or accrual. For example, a contingent loss may have been recorded as a note disclosure because at the date of the financial statements, the entity had only a reasonable possibility that a loss could be incurred. If a subsequent event occurs that (in the auditors‘ judgment) makes it probable that a liability has been incurred, the contingent liability will now have to be accrued in the financial statements (assuming that an amount can be estimated).

11.68

11.69

Subsequent Events Procedures a.

The purpose of a review for subsequent events is to determine whether there have been any material transactions or events following year-end that have a significant effect on the financial statements and could require adjustment to or disclosure in the financial statements. The review for subsequent events normally ends as of the date of the auditor‘s report (February 20).

The following procedures would be performed to identify subsequent events:



Obtaining an understanding of the procedures performed by management to identify subsequent events.



Inquiring of management and those charged with governance as to the existence of subsequent events (and subsequently corroborate this inquiry through written representations).



Reading minutes of meetings of owners, management, or those charged with governance held after the date of the financial statements.



Reviewing the entity‘s latest interim financial statements (if applicable).

Subsequent Events–Cases 1.

a. This would have come to auditors‘ attention through inquiries of client officers and key personnel, review of the minutes of the meetings of the board of directors and stockholders, or through local news media. b.

The details of the construction of the express highway would need to be disclosed in the footnotes to the financial statements. This disclosure would be required because it affects an asset (land) held by Olars.

It is improbable that the auditors would learn the source of the $25,000 unless it was revealed in a discussion with the president or his personal accountant or unless auditors prepared the president‘s personal income tax return.

Disclosing the loan in the balance sheet as a loan from an officer would be sufficient. The source of the funds would not be disclosed because it is the officer‘s personal business and has no effect upon Olars‘ financial statements.

The additional liability for the ore shipment would have been revealed to auditors by scanning the January transactions. The regular examination of transactions and related documents such as purchase contracts would have caused the auditors to note the item for subsequent follow-up to determine the final liability. In addition, the written representations might have mentioned the potential liability.

The inventory and accounts payable balances would need to be adjusted by amount of the additional charge, $9,064 [[$20,600 x (0.72/0.50)] – $20,600 = $9,064]. Because of this adjustment, no further disclosure would be necessary.

Auditors might learn of the agreement to purchase the treasurer‘s stock ownership through their inquiries of management and legal counsel, examination of the minutes of the meetings of the board of directors and stockholders and subsequent reading of the agreement. The physical absence of the treasurer from Olars‘ headquarters might also arouse the auditors‘ curiosity.

The details of the agreement would be disclosed in the footnotes to the financial statements because the use of company cash for the repurchase of stock and the change in the amount of stock held by stockholders might have a significant impact on subsequent years‘ financial statements.

Usually, a management change, such as the treasurer‘s resignation, does not require disclosure in the financial statements. The details underlying the separation (personal disagreements and divorce) need not be disclosed. 5.

11.70

Auditors would learn of the reduced sales and of the strike through inquiries of management, review of financial statements for January, scanning transactions, and general observations during the engagement.

Disclosure should be made in the footnotes to the financial statements of these conditions and the facts available at the date of the financial statements. This would be an example of a subsequent event that provides evidence about conditions that arose after the date of the financial statements for which disclosure is required.

Subsequently Discovered Facts The manner in which Faultless treated the discovery of facts after the audit report release date is inappropriate. Once the chief executive of Hopkirk refused to make proper disclosure, Faultless should notify management, regulatory agencies (such as the SEC), and any individuals known to be relying on the financial statements that the auditor‘s report cannot be relied upon. If Faultless determines that the subsequently discovered facts would require revision to the financial statements, the nature of the matter and effect on the financial statements should also be included in their notification. However, public notification such as that in The Wall Street Journal is not appropriate.

11.71

Omitted Audit Procedures a. 1.

If it is discovered that an important audit procedure was omitted, auditors should consult legal counsel and take the following actions: 

Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion.



Determine whether any persons are currently relying or likely to rely on the reports.



If the omitted procedure impairs auditors‘ present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion.



If as a result of subsequent application of the omitted procedure or alternative procedures, auditors become aware of facts that existed at the date of their report, they should formally withdraw the original reports, issue revised reports, and inform persons currently relying on the financial statements.

If after reviewing the audit documentation auditors determined that procedures were performed that compensate for the omitted procedure, the omitted procedure would not have to be performed. Auditors should document their decision and their support for this decision.

If auditors become aware of material new information that should have been disclosed in the financial statements, they should follow the guidelines for subsequently discovered facts, which require that they request the client to disclose necessary information to

persons known to be relying on the financial statements and auditor‘s reports. If the client refuses to do so, auditors should notify each member of the board of directors that they will be notifying regulatory agencies having jurisdiction over the client (such as the Securities and Exchange Commission) as well as other persons who are relying on the reports. 11.71

Omitted Audit Procedures (continued)

Case 1: You should document the decision that the specific procedures considered to have been omitted by the internal inspection reviewers were not considered necessary in the valuation of Wildcat‘s inventory. You should cite the specific performed procedures that you feel compensate for the procedure the reviewers thought necessary. Case 2: You should immediately notify the partners of Arthur Hurdman that the December 31 financial statements of Top Stove are not correct. They should consult legal counsel and notify the client and ask the client to disclose to users that the financial statements are in error. The financial statements should be corrected as soon as possible and reissued with Arthur Hurdman‘s reports.

11.72

Subsequent Events, Subsequently Discovered Facts, and Omitted Procedures a.

The class action lawsuit and deterioration of Raider‘s customer‘s financial condition are subsequently discovered facts. Because Ralph learned of these events prior to the audit report release date, Raider‘s financial statements and disclosures should have been modified to include information related to these events (Raider‘s assertion about required disclosure of these events is incorrect). However, Raider‘s financial statements did not disclose these events, nor were Ralph‘s reports modified in response to these events. Assuming that (1) the facts affect Raider‘s financial statements and Ralph‘s reports and (2) persons continue to rely on the financial statements and Ralph‘s reports, Ralph should request that Raider disclose information about these events and their impact on the financial statements to persons known to be relying on the financial statements. NOTE TO INSTRUCTOR: You may wish to note that Ralph may be subject to liability in this case because he was clearly aware of these events and should have insisted upon their disclosure in Raider’s financial statements or modification of his report prior to its release.

In this case, Ralph did not learn of these events until following the audit report release date. With respect to the dividend, because the date of declaration was after the date of the auditor‘s report, no action is necessary. With respect to the line of credit, because it was activated prior to the date of the auditor‘s report (February 3), Ralph should treat this as a subsequently discovered fact. Assuming that (1) the facts affect Raider‘s financial statements and Ralph‘s reports and (2) persons continue to rely on the financial statements and Ralph‘s reports, Ralph should request that Raider disclose information about these events and their impact on the financial statements to persons known to be relying on the financial statements.

The failure to evaluate impairment of the carrying value of property, plant, and equipment is an example of an omitted audit procedure. In this case, Ralph should consider whether (1) the omitted procedures are important in supporting his opinion and (2) individuals are currently relying on Raider‘s financial statements and Ralph‘s reports. If so, Ralph should perform the omitted procedure or alternative procedures, withdrawing his original reports if the results of performing these procedures suggest that Raider‘s financial statements and Ralph‘s reports are no longer appropriate.

11.73

11.74

Various Completion Matters a.

This is an example of a subsequent event; because this event relates to information already disclosed in Anderson‘s financial statements (accounts receivable from sales made to Jones), Allison should insist that Anderson‘s financial statements be adjusted to consider the most recent information related to Jones‘ financial condition.

Written representations should be dated as of the date of the auditor‘s reports (audit completion date). As a result, Carmelo should request that Nugget reissue the representations with a date of February 9, 2021.

This is an example of a subsequently discovered fact. Because this settlement does not have a material effect on either Manning‘s financial statements or Colt‘s ability to support his previously issued opinion on Manning‘s financial statements, no further action is necessary by Manning.

This situation is somewhat ambiguous. Because this event was not known and the conditions did not exist at the date of Alta‘s report, Alta would not be responsible for this information. However, if Saxe discloses information related to the potential loss from the flood in its financial statements, Alta would ordinarily examine the fairness of this disclosure and either extend the date of the auditor‘s report to reflect this auditor‘s report date or dual date the report. Another possibility is that the information would be disclosed and marked ―unaudited.‖

Myron must accumulate the effects of these misstatements on the financial statements with those identified in prior years. In addition, Myron to is required to communicate any uncorrected misstatements other than those Myron believes to be trivial to individuals charged with governance of Glomco.

Because Jill believes that the omitted procedure affects her ability to support the opinion on Blankenship‘s financial statements and persons continue to rely on her report, she should undertake to perform the omitted procedure or alternate procedures.

Attorney Letter Responses a.

NOTE TO INSTRUCTOR: Students’ responses may vary depending on their interpretation of the disclosures. 1.

This response is too vague for adequate information. More evidence would be required to support the claim that the plaintiffs will have ―serious problems‖ establishing Omega‘s liability.

Because it appears that Omega will be able to successfully defend the action and, if not, the loss would be nominal, it appears that the likelihood of a material loss would be remote.

If the case is without merit, it appears that the likelihood of a material loss would be remote.

―Meritorious‖ does not mean strong or ―adequate.‖ The phrases ―reasonable chance,‖ ―adequate defense,‖ and ―less than the damages claimed‖ all indicate potential issues. More information is needed.

Plaintiffs‘ counsel would probably assert the merits of the plaintiff‘s case, suggesting that the auditors‘ client (defendant) will certainly lose large damages. However, it is important to note that auditors would not obtain representations from the plaintiffs‘ counsel regarding the outcome of litigation against a client.

11.75

Accounting for a Contingency: Attorney Letter Information a.

Both of these amounts should be considered with some skepticism. While MALDEF may indeed seek $250,000 from the city, this amount does not necessarily represent the amount of damages that will be paid (and the amount at which the liability might be settled). The fact that the attorney letter indicates that the damages could be between $30,000 and $175,000 provides some evidence that a negative outcome may occur but does not provide any reliable information as to the amount of that outcome.

The financial statements should disclose the verdict and mention the possibility of a monetary settlement. This would require adjustment of the financial statements (if the litigation had commenced prior to December 31, 2020) or disclosure of the litigation (if the litigation had commenced after December 31, 2020).

CHAPTER 12 Reports on Audited Financial Statements LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises and Problems

Understand the types of reports that accompany an entity‘s financial statements and the content of the auditors‘ standard (unmodified) report.

1, 2, 3, 4, 5, 6,

28, 29, 30, 31

Identify situations in which language in the standard (unmodified) report is modified and the type of opinions issued in those situations.

7, 8, 9, 10, 11, 12, 13, 14, 15, 16

32, 33, 34, 35, 36, 37, 38 (*)

48, 49, 50, 51, 52, 53, 54 (*), 55 (*), 56 (*), 57 (*), 58 (*), 59, 61, 66, 67, 69, 70 (*)

Identify situations in which auditors add explanatory language to an unmodified opinion.

17, 18, 19, 20, 21

38 (*), 39, 40, 41, 42

54 (*), 55 (*), 56 (*), 57 (*), 58 (*), 63 (*), 64, 68, 70 (*)

Identify other circumstances affecting auditors‘ reporting responsibilities and explain how they affect auditors‘ reports on an entity‘s financial statements.

22, 23, 24, 25, 26, 27

43, 44, 45, 46, 47

60, 62, 63 (*), 65

A.1, A.2, A.3, A.4, A.5, A.6

A.7, A.8, A.9, A.10, A.11, A.12

A.13, A.14, A.15

5. Understand auditors‘ reporting responsibility for the financial statements and internal control over financial reporting for issuers

(Appendix 12.A)

(*) indicates that an item corresponds to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS 12.1

The reports that accompany an issuer‘s financial statements are mandatory reports on the (1) effectiveness of internal control over financial reporting (prepared by management), (2) effectiveness of internal control over financial reporting (prepared by auditors), and (3) fairness of financial statements and related disclosures (prepared by auditors). A report on the fairness of financial statements and related disclosures may accompany a non-issuer‘s financial statements. These reports are not mandatory and are based on user demand.

12.2

There are no mandated audit requirements for the financial statements of non-issuers. Audits for these entities may result from (1) requirements of regulatory bodies other than the SEC or (2) demand from thirdparty users of financial statements (lenders and investors). Issuers are required to file audited financial statements with the SEC within 60 to 90 days (depending upon their size) of their fiscal year-end. Thus, issuers are required to have an audit examination on an annual basis.

12.3

The auditors‘ report is addressed to the person(s) who retain the audit team and pay the fee. For issuers, this party would be the board of directors and shareholders. For non-issuers, potential addressees include the board of directors and shareholders or the party who requested the audit (prospective or current lenders, prospective or current creditors, and prospective or current investors).

12.4

The four major sections of the standard (unmodified) auditors‘ report are:

12.5

Opinion: Identifies the financial statements and years examined by the audit team and the opinion on the financial statements.

Basis for Opinion: Indicates that the audit was conducted according to GAAS, the audit team was independent and met other ethical responsibilities, and that the audit evidence provides a basis for the opinion.

Responsibilities of Management for the Financial Statements: Indicates that the entity‘s management is responsible for the fairness of the financial statements and the design, implementation, and maintenance of internal control over financial reporting.

Responsibilities for the Audit the Financial Statements: Discusses the audit team‘s responsibility to obtain reasonable assurance regarding the fairness of the financial statements, identifies several important components of a GAAS audit, and discusses the audit team‘s responsibility to communicate matters to those charged with governance.

Key audit matters are those matters that are the most significant in the audit and include areas of higher risk, areas requiring significant audit team and management judgment, or significant transactions or events. If engaged to communicate key audit matters, the auditors would include a Key Audit Matters section in their report and, for each key audit matter identified, indicate (1) why the matter was considered to be a key audit matter and (2) how the matter was addressed during the audit.

12.6

Unmodified (or unqualified) opinions indicate that the financial statements present the financial condition, results of operations, and cash flows in accordance with GAAP. Qualified opinions indicate that, with the exception of one or more non-pervasive issues, the financial statements present the financial condition, results of operations, and cash flows in accordance with GAAP. Adverse opinions indicate that the financial statements do not present the financial condition, results of operations, and cash flows in accordance with GAAP. Disclaimers of opinion do not express an opinion on the fairness of the entity‘s financial statements.

12.7

If a departure from GAAP exists and the effect is immaterial, then an unmodified opinion may be issued. If the effect of the departure is material (but not pervasive) and isolated to a single event, then a qualified opinion would be issued. If the effect is both material and pervasive, the auditors should issue an adverse opinion.

12.8

Qualified opinions indicate that, ―except for‖ the effects of an isolated departure from GAAP, the financial statements are presented in accordance with GAAP. Adverse opinions indicate that the financial statements are not presented in accordance with GAAP. Clearly, the wording used in the adverse opinions represents more material and pervasive departures from GAAP and more serious concerns on the part of the audit team.

12.9

The following modifications would be appropriate to reflect departures from GAAP:

12.10



The Opinion section (which would be labeled either ―Qualified Opinion‖ or ―Adverse Opinion‖) would be modified to express either a qualified opinion or an adverse opinion and refer to the departure from GAAP.



For an adverse opinion, the phrase ―in all material respects‖ would be omitted.



The Basis for Opinion section (which would be labeled either ―Basis for Qualified Opinion‖ or ―Basis for Adverse Opinion‖) would describe the nature of the departure from GAAP and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖ or ―basis for our adverse audit opinion‖.

A client-imposed scope limitation results from management‘s refusal to provide access to evidence or otherwise limit the audit team‘s application of auditing procedures while a circumstance-imposed scope limitation occurs when circumstances beyond the audit team‘s or client‘s control result in the inability of auditors to perform certain procedures. Because of the deliberate and intentional nature of client-imposed scope limitations, these scope limitations are of more concern to auditors than circumstance-imposed scope limitations.

12.11

If audit teams are able to perform alternative procedures, the standard (unmodified) report would not be modified.

12.12

Assuming that alternative procedures cannot be performed, the auditors‘ reporting options are as follows:

12.13

1. 2. 3.

If the scope limitation is not material, an unmodified opinion (standard report) is issued. If the scope limitation is material, but not pervasive, a qualified opinion is issued. If the scope limitation is highly material and pervasive, a disclaimer of opinion is issued.

A report qualified for a scope limitation would modify the standard (unmodified) report as follows:

12.14



The Opinion section (which would be labeled ―Qualified Opinion‖) would be modified to express a qualified opinion and refer to the scope limitation.



The Basis for Opinion section (which would be labeled ―Basis for Qualified Opinion‖) would describe the nature of the scope limitation and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

A report in which the opinion is disclaimed because of a scope limitation would modify the standard (unmodified) report as follows: 

The Opinion section would be labeled ―Disclaimer of Opinion‖, indicate that the audit team was ―engaged to audit‖ the financial statements, refer to the scope limitation, and express a disclaimer of opinion



The Basis for Opinion section (which would be labeled ―Basis for Disclaimer of Opinion‖) would describe the nature of the scope limitation and its effects (accounts, dollar amounts, percentages, etc.).



The standard paragraph in the Basis for Opinion section indicating that a GAAS audit was performed is deleted.



The Responsibilities for the Audit of the Financial Statements section would be modified to (1) indicate that the audit team was not able to obtain sufficient appropriate evidence, (2) delete language describing an audit and required communication with those charged with governance, and (3) include a sentence on requirements for independence and ethical responsibilities.

Group auditors perform the audit of a material portion of the consolidated entity‘s financial statements; component auditors are engaged to audit divisions, subsidiaries, or segments that are included in the group financial statements. The issue introduced when component auditors are involved in the audit of group financial statements is that the group auditors‘ opinion on the group financial statements is based, in part, on the work of the component auditors.

12.15

When component auditors are involved in the audit of group financial statements, group auditors can assume responsibility for the component auditors‘ work; if so, no reference is made to the component auditors‘ work in the group auditors‘ report (the standard (unmodified) report can be issued). If group auditors decide to refer to the work and reports of component auditors, they would modify the Opinion section of their report to indicate the involvement of component auditors.

12.16

The group auditors‘ reference in their report to component auditors is not a scope limitation. The reference only shows the involvement of component auditors in the audit of group financial statements.

12.17

12.18

Emphasis-of-matter paragraphs and other-matter paragraphs are paragraphs added to an otherwise unmodified opinion that provide additional information to users. 

Emphasis-of-matter paragraphs provide information fundamental to users‘ understanding of the financial statements.



Other-matter paragraphs provide information relevant to users‘ understanding of the audit, the audit team‘s responsibility, or auditors‘ report.

The following matters cause audit team to modify their reports to identify inconsistent applications of GAAP:    

Change in accounting principles (from GAAP to GAAP). Change in the form of reporting entity. Change from a principle not conforming to GAAP to one that is GAAP. Change in an accounting principle that is inseparable from a change in accounting estimate.

12.19

Going-concern uncertainties are situations in which questions are raised about the entity‘s ability to continue operations and meet its obligations as they become due. During the audit, audit teams are required to assess an entity‘s ability to continue as a going concern for a period not to exceed one year beyond the date the financial statements are issued.

12.20

When going-concern uncertainties exist, auditors may either include a section (with the heading Substantial Doubt About the Entity’s Ability to Continue as a Going-Concern) to an unmodified opinion or disclaim an opinion on the entity‘s financial statements. Disclaimers would typically be issued when the going-concern uncertainties are more serious and pervasive.

12.21

Auditors are required to report on management‘s responsibility for other information, the auditors‘ responsibility for other information, and identify any inconsistenc(ies) noted between the other information and the audited financial statements. This information is reported in a separate section of the auditors‘ report.

Auditors are required to report on required supplementary information when such information is provided with the financial statements and footnotes accompanying the financial statements. An other-matter paragraph is added to their report on the financial statements that identifies the supplementary information, describes any procedures performed with respect to this information, and identifies any issues related to this information.

12.22

Comparative financial statements are financial statements for more than one period presented in side-byside format. The issue introduced when financial statements are presented in comparative form is that users may assume auditors have examined all comparative years presented.

12.23

An updated report is a report on prior years‘ financial statements that is based on both the prior years‘ audits and on information that has come to light in the most recent audit. An updated report may be modified for events occurring subsequent to the date of the initial report. A reissued report is a copy of a previously issued report that auditors provide or grant entities permission to use in another document after its delivery date. This report is not modified to consider events occurring subsequent to the date of the initial report.

12.24

If auditors wish to express a different opinion on prior years‘ financial statements in the current report than in a previously issued report, the current report would contain an other-matter paragraph that states:   

12.25

12.26

12.27

The type of opinion expressed in the previously issued report (and date of the report) The basis (reasons) for that opinion The present opinion is different from that expressed in the previous report

If predecessor auditors examined prior years‘ financial statements presented in comparative form, the current auditors can:  

Present the predecessor auditors‘ report Include an other-matter paragraph to their report, indicating the date of the predecessor auditors‘ report and opinion expressed by the predecessor auditors (in this case, the predecessor auditors are not identified by name)

When engaged to report on summary financial statements, auditors should issue a separate report that indicates whether the information in the summary financial statements is fairly stated in all material respects in relation to the complete financial statements.

When engaged to report on supplementary information, auditors can either issue a separate report on the supplementary information or include an other-matter paragraph to their report on the financial statements. In either case, auditors will indicate whether the supplementary information is fairly stated, in all material respects, to the financial statements as a whole.

When audit teams are not independent with respect to the entity, they should issue a disclaimer of opinion that indicates they are not independent. However, the report should not mention any reasons for the lack of independence.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 12.28

12.29

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Auditors explicitly report on GAAP and express an opinion; auditors implicitly report on consistency and going concern. Consistency is implicitly (and not explicitly) reported upon. Auditors explicitly report on GAAP and express an opinion; auditors implicitly report on consistency and going concern. The implicit reporting on consistency is the only correct option in this choice. The auditors‘ responsibility is explicitly stated in the Responsibilities for the Audit of the Financial Statements section of the report. The auditors‘ responsibility is explicitly stated (not unstated) in the Responsibilities for the Audit of the Financial Statements section. The auditors‘ responsibility is stated in the Responsibilities for the Audit of the Financial Statements section, not the Opinion section. The auditors‘ responsibility is explicitly stated in the Responsibilities for the Audit of the Financial Statements section, not the Basis for Opinion section.

12.30

12.31

12.32

12.33

12.34

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement is not included in the auditors’ standard (unmodified) report, the item labeled “correct” would not be included and those labeled “incorrect” would be included. a. b. c.

Incorrect Incorrect Incorrect

Correct

The standard (unmodified) report identifies the financial statements. The standard (unmodified) report provides a general description of an audit. The standard (unmodified) report expresses an opinion about accordance with GAAP. The standard (unmodified) report does not call for economic analysis or commentary in an emphasis-of-matter paragraph.

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement is not true, the item labeled “correct” is not true and those labeled “incorrect” are true. a.

Incorrect

Correct

Incorrect

b. c. d.

Incorrect Incorrect Correct

Audit examinations for non-issuers are based on user demand, but are required by the SEC for issuers. The report for both issuers and non-issuers will express an opinion on the entity‘s financial statements. The reporting requirement for internal control over financial reporting is related to the audit of issuers, not non-issuers Management is responsible for the fairness of the financial statements for both issuers and non-issuers. Neither unmodified opinions or disclaimers of opinion are appropriate for material departures from GAAP. The unmodified opinion is not appropriate for material departures from GAAP. The unmodified opinion is not appropriate for material departures from GAAP. Because this is a material departure from GAAP, the reporting options are to issue either a qualified or adverse opinion.

NOTE TO INSTRUCTOR: Since this question asks students to identify which situation would not require modification of the Opinion section, the item labeled “correct” is would not require modification and those labeled “incorrect” would require modification. a.

Incorrect

Correct

Incorrect

Correct

Incorrect

The Opinion section would be modified to express a qualified or adverse opinion for a material departure from GAAP. The Opinion section would be modified to note that the opinion was based on the report of other auditors if component auditors were used in the audit of group financial statements. The Opinion section would be modified to express a qualified opinion or disclaimer of opinion for a significant scope limitation. A change from one generally accepted accounting principle to another would require the addition of an emphasis-of-matter paragraph, but would not require the Opinion section to be modified. A qualified opinion would not be appropriate for the audit of group financial statements. A qualified opinion would not be appropriate for the audit of group financial statements and would be appropriate for a scope limitation. A qualified opinion would not be appropriate for the audit of group financial statements and would be appropriate for a scope limitation. A qualified opinion would be appropriate for a scope limitation.

12.35

12.36

12.37

12.38

12.39

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

This is the audit team‘s initial reaction if an auditing procedure cannot be applied. Audit teams would only withdraw from an engagement because of the inability to perform an auditing procedure after other actions were taken and if the scope limitation was deemed highly serious. The audit team would assess the significance of the scope limitation only after determining whether alternative procedures are available and can be performed. Audit teams would not undertake this action in response to a scope limitation. While the Basis for Opinion section would be modified, the Responsibilities for the Audit section would not be modified. The Basis for Opinion section would be modified, but the Responsibilities for the Audit section would not be modified. The Basis for Opinion section would be modified, but the Responsibilities for the Audit section would not be modified. While the Responsibilities for the Audit section would not be modified, the Basis for Opinion section would be modified. Modification of the report to indicate the work of component auditors with an unmodified opinion is a viable reporting option. If the group auditors wish to issue the standard (unmodified) report and not mention the component auditors in their report, they need to consider and evaluate the component auditors‘ work. The group auditors assume primary responsibility when component auditors are involved in the audit of group financial statements. When the component auditors are named, their reports must be presented along with the group auditors‘ report.

NOTE TO INSTRUCTOR: Since this question asks students to identify when disclaimers of opinion cannot be issued, the item labeled “correct” represents a situation when disclaimers cannot be issued and those labeled “incorrect” represents situations when disclaimers can be issued. a.

Incorrect

c. d.

Incorrect Correct

Correct

Incorrect

A disclaimer of opinion when going-concern uncertainties exist is permitted when uncertainties are highly material and pervasive. A disclaimer of opinion based on a scope limitation is permitted when the nature of the limitation is material and pervasive. Auditors must always disclaim an opinion when they are not independent. Auditors cannot disclaim an opinion when departures from GAAP exist and they have conducted a GAAS audit (qualified or adverse opinions are appropriate). The choice between an unmodified opinion with reference to going-concern matters or a disclaimer of opinion depends on the audit team‘s perception of the magnitude of the uncertainty. The standard (unmodified) report without reference to the going-concern matter is not appropriate in this circumstance. Because the disclosures are adequate, a qualified opinion or adverse opinion for GAAP departure would be inappropriate. An unmodified opinion with reference to going-concern matters or a disclaimer of opinion would be appropriate reporting options; therefore, neither a standard (unmodified) report or adverse opinion would be appropriate.

12.40

12.41

12.42

Incorrect

Correct

Incorrect

Correct

Incorrect

Changes in estimates do not require an emphasis-of-matter paragraph related to consistency. Error corrections not involving a change in principle do not require an emphasisof-matter paragraph related to consistency. Changes in the consolidated entity by reason of sale of a subsidiary do not require an emphasis-of-matter paragraph related to consistency. Changing from FIFO to LIFO is a change in accounting principle, which requires an emphasis-of-matter paragraph related to consistency. The change in accounting methods would be identified in an emphasis-of-matter paragraph, not in the Opinion section. The change in accounting methods would be identified in an emphasis-of-matter paragraph, not in the Basis for Opinion section. Emphasis-of-matter paragraphs discuss issues related to users‘ understanding of the financial statements, such as consistency. Other-matter paragraphs discuss issues related to users‘ understanding of the audit, the auditors‘ responsibility, or auditors‘ report and not matters such as consistency.

NOTE TO INSTRUCTOR: Since this question asks students to identify the item that would not be addressed in an emphasis-of-matter paragraph or other-matter paragraph, the item labeled “correct” would not be addressed and the items labeled “incorrect” would be addressed. a.

Incorrect

A change in accounting principles would be referenced in an emphasis-of-matter paragraph. Information relating to a material acquisition would be referenced in an emphasis-of-matter paragraph. Material departures from GAAP would be referenced in the Basis for Opinion section, not an emphasis-of-matter paragraph or other-matter paragraph. Procedures performed on supplementary information required by the Financial Accounting Standards Board would be referenced in an other-matter paragraph.

Incorrect

Correct

Incorrect

12.43

a. b. c. d.

Incorrect Correct Incorrect Incorrect

The prior audit must be described regardless of the type of opinion issued. The predecessor auditors should be named only if their report is included. The type of opinion must be stated. The predecessor auditors should not be named unless their report is included.

12.44

Incorrect

Correct

The report should indicate the type of opinion issued by the other firm on the prior years‘ financial statements, and not disclaim an opinion on those financial statements. The report should indicate the type of opinion issued by the other firm on the prior years‘ financial statements. The current auditor would not be required to perform any procedures to verify the opinion on the prior years‘ financial statements. Both the report and type of opinion expressed on prior years‘ financial statements should be referenced in the report on the current year‘s financial statements.

12.45

12.46

12.47

Incorrect

Correct

Incorrect

Correct

Incorrect

a. b.

Incorrect Correct

Incorrect

When financial statements are presented in comparative form, all years should be referenced in the auditors‘ report. The auditors‘ report on the prior years‘ financial statements would not be withdrawn. If a previously issued opinion is no longer appropriate, the auditors‘ report would reference the type of opinion issued as well as the fact that the current opinion differs from the opinion originally issued. The auditors‘ report should reference the previously issued opinion to alert users that the current opinion differs. The successor auditor should not assume responsibility for the work of the predecessor auditor. The successor auditor would only fail to reference the year(s) examined by the predecessor auditor if the predecessor auditors‘ report was presented. This is the appropriate action when the predecessor auditors‘ report is not presented. The successor auditors‘ report would not disclaim an opinion on the comparative year(s), since an opinion on these financial statements was expressed by the predecessor auditor. The auditors‘ report should reference all years presented. Auditors are responsible for considering whether their previous opinion(s) are still appropriate. If the opinion(s) issued in comparative years are no longer appropriate, the auditors can modify the opinion in their current report. Auditors are responsible for considering whether their previous opinion(s) are still appropriate, even when an unmodified opinion is issued.

SOLUTIONS FOR EXERCISES AND PROBLEMS 12.48

Basic Reports If the amounts involved are immaterial, auditors can issue the standard report (unmodified opinion); otherwise, materiality and pervasiveness affects the choice of auditors‘ reports as follows:

Material but not Pervasive

Material and Pervasive

Scope limitation on examination of accounts receivable.

―Except for‖ language used to qualify the opinion.

Disclaimer of opinion.

Departure from GAAP (failure to accrue revenue)

―Except for‖ language used to qualify the opinion for the GAAP departure.

Adverse opinion.

Departure from GAAP (failure to capitalize leases)

―Except for‖ language used to qualify the opinion for the GAAP departure.

Adverse opinion.

Departure from GAAP (uncertainty related to the amount of damage that might eventually be confirmed by an appeals court ruling)

―Except for‖ language to qualify the opinion for a GAAP departure from the failure to record a loss and liability.

Adverse opinion, if unrecorded loss and related disclosures are pervasive. (Note: if auditors believe that the amount awarded might seriously threaten the going-concern status of the entity, a disclaimer of opinion might be issued)

12.49

Departures from GAAP a.

Auditors would issue the standard (unmodified) report, with no modification or reference to the departure from GAAP.

Auditors would express a qualified opinion, which would modify the standard (unmodified) report as follows:



Label the Opinion section ―Qualified Opinion‖ and modify the paragraph to express a qualified opinion and refer to the departure from GAAP.



Label the Basis for Opinion section ―Basis for Qualified Opinion‖ and include a paragraph that describes the departure from GAAP, accounts affected by the departure, and amounts.



In the Basis for Opinion section, modify the phrase ―basis for our audit opinion‖ to ―basis for our qualified audit opinion‖.

Auditors would express an adverse opinion, which would modify the standard (unmodified) report as follows: 

Label the Opinion section ―Adverse Opinion‖ and modify the paragraph to express an adverse opinion and refer to the departure from GAAP.



In the Opinion section, omit the phrase ―in all material respects‖.



Label the Basis for Opinion section ―Basis for Adverse Opinion‖ and include a paragraph that describes the departure from GAAP, accounts affected by the departure, and amounts.



In the Basis for Opinion section, modify the phrase ―basis for our audit opinion‖ to ―basis for our adverse audit opinion‖.

12.50

Scope Limitations a.

A client-imposed scope limitation is a situation in which audit teams cannot gather sufficient appropriate evidence because of the client‘s deliberate refusal to provide access to evidence or otherwise limit the audit team‘s application of auditing procedures. A circumstance-imposed scope limitation is a situation in which audit teams cannot gather sufficient appropriate evidence because of circumstances beyond the audit team‘s and client‘s control. Because of potential implications on the client‘s integrity and concerns as to the client‘s rationale for limiting the auditors‘ procedures, a client-imposed scope limitation is of more concern to audit teams than a circumstance-imposed scope limitation.

Scope limitations impact the auditors‘ ability to express an opinion on the entity‘s financial statements because of the potential inability of auditors to identify misstatements that might have been revealed had the procedures related to the scope limitation been performed.

If the account balances affected by the scope limitation are not material, auditors would issue an unmodified opinion on the client‘s financial statements.

If alternative procedures are performed and support the accounts affected by the scope limitation, auditors would issue an unmodified opinion on the client‘s financial statements.

Because the scope limitation is material and the audit team is unable to perform alternative procedures, either a qualified opinion or disclaimer of opinion would be issued on the client‘s financial statements. The type of opinion issued by the auditors would depend upon the materiality and pervasiveness of the scope limitation, with disclaimers being issued for more significant scope limitations (those involving material and pervasive accounts).

The auditors‘ report would not be affected; a standard (unmodified) report would be issued.

The auditors‘ report would not be affected; a standard (unmodified) report would be issued (the report would not need to mention that alternative procedures were performed by the audit team).

The auditors‘ report modifications are shown below. The modifications to the auditors‘ standard (unmodified) report differ, depending upon whether a qualified opinion or disclaimer of opinion is issued.

Opinion Section

Qualified

Disclaimer

Label section ―Qualified Opinion‖, refer to the scope limitation, and express a qualified opinion

Label section ―Disclaimer of Opinion‖, refer to the scope limitation, and express a disclaimer of opinion Indicate that the audit team was ―engaged to audit‖ (and not that they ―audited‖) the financial statements

Basis for Opinion Section

Responsibilities for the Audit Section

Label section ―Basis for Qualified Opinion‖

Label section ―Basis for Disclaimer of Opinion‖

Describe scope limitation and its effects (accounts, dollar amounts, percentages, etc.).

Modify phrase ―basis for our audit opinion‖ to ―basis for our qualified audit opinion‖

Delete standard paragraph indicating that a GAAS audit was performed

No modification

Modify first paragraph to note that the audit team was not able to obtain sufficient appropriate evidence Delete paragraphs describing an audit and required communication with those charged with governance Include sentence on requirements for independence and ethical responsibilities

12.51

Scope Limitations Scenario A: Bruce can issue an unmodified opinion (standard report), since alternative procedures were performed and allowed Bruce to be satisfied as to the ending balances in inventory. Scenario B: In this situation, Bruce is unable to evaluate the ending balances in inventory. As a result, he would issue either a qualified opinion or disclaimer of opinion on the financial position, results of operations, and cash flows for the year ended December 31, 2020. Bruce‘s choice of opinions would depend upon the materiality and pervasiveness of the inventory account to the financial statements. Because this is a circumstance-imposed limitation resulting from Bruce‘s late appointment, the ramifications are not as serious in terms of other areas of the audit examination. Scenario C: This scenario introduces some unique circumstances. While it appears that Bruce has gathered sufficient appropriate evidence with respect to Weaver‘s ending inventory balances and would be able to issue an unmodified opinion (standard report), some concerns would exist with respect to Weaver‘s request that Bruce not observe physical inventories. Clearly, Bruce should consider the reasons for this request and the potential impact of this request on his ability to rely on Weaver‘s representations related to other matters in the audit examination. Scenario D: In this scenario, the inability of Bruce to observe inventories or perform alternative procedures represents a scope limitation that precludes the issuance of an unmodified opinion. While either a qualified opinion or disclaimer of opinion could be issued in this situation, the fact that this is a client-imposed scope limitation suggests that a disclaimer of opinion would be more appropriate. Clearly, Bruce should consider the reasons for this request and the potential impact of this request on his ability to rely on Weaver‘s representations related to other matters in the audit examination.

12.52

Scope Limitations a.

In this situation, the fact that Brady is only able to obtain evidence related to one of Patriot‘s warehouses (which represents 20 percent of the inventories) and that Brady does not feel this level of testing provides sufficient appropriate evidence would likely be considered a scope limitation. This is a circumstance-imposed scope limitation, assuming that Patriot did not restrict or otherwise limit Brady from observing inventory counts in its remaining warehouses.

Assuming Patriot did not restrict or limit Brady from observing inventory counts in its remaining warehouses and the effects of the scope limitation were not pervasive, Brady would issue a qualified opinion on Patriot‘s financial statements. The standard (unmodified) report would be modified as follows: 

The Opinion section would be labeled ―Qualified Opinion‖, refer to the scope limitation, and express a qualified opinion



The Basis for Opinion section would be labeled ―Basis for Qualified Opinion‖ and include a paragraph that describes the scope limitation and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

Alternatively, if Brady felt that the scope limitation was of such a level of materiality and pervasiveness that a disclaimer of opinion was appropriate, his report would be modified as follows: 



The Basis for Opinion section would be labeled ―Basis for Disclaimer of Opinion‖ and include a paragraph that describes the scope limitation and its effects (accounts, dollar amounts, percentages, etc.).



The standard paragraph in the Basis for Opinion section indicating that a GAAS audit was performed is deleted.



The Responsibilities for the Audit of the Financial Statements section would be modified to note that the audit team was not able to obtain sufficient appropriate evidence, delete paragraphs describing an audit and required communication with those charged with governance, and include a sentence on requirements for independence and ethical responsibilities.

Some alternative procedures that could be performed by Brady include: 

Physically observing inventories at other warehouses either shortly before or shortly following the date of the financial statements and using perpetual inventory records to reconcile those counts to ending counts.



Obtaining a confirmation of inventory counts from custodians at other warehouses.



Utilizing component auditors to observe physical inventory counts at other warehouses.

The type of opinion issued would depend upon the alternative procedures performed. With one exception, assuming the alternative procedures provided Brady with sufficient appropriate evidence as to the fairness of Patriot‘s inventories, an unmodified opinion (standard report) would be issued. This report would not reference the fact that Brady did not observe inventory counts at the remaining warehouses nor the alternative procedures performed. The use of component auditors would require a modification of Brady‘s report. If Brady decided to utilize component auditors and refer to their work, the report would be modified to indicate that component auditors performed part of the examination and to provide an indication as to the magnitude of the inventories related to their procedures. Brady‘s opinion on Patriot‘s financial statements would still be unmodified in this instance.

12.53

Audit of Group Financial Statements a.

Michaels should: 1.

Make inquiries concerning the professional reputation and standing of Thomas

Obtain a representation from Thomas that Thomas is independent under the requirements of the AICPA or the requirements of the SEC, as appropriate

Adopt appropriate measures to ensure the coordination of activities with Thomas in order to achieve a proper review of matters affecting the consolidating or combining of accounts in the financial statements. In order to accomplish this, Michaels must ascertain that: 

Thomas is aware that the financial statements of the component Thomas has examined are to be included in the financial statements on which Michaels will report and that Thomas‘s report thereon will be relied upon (and, where applicable, referred to) by Michaels.



Thomas has knowledge of the relevant financial reporting requirements for statements and schedules to be filed with regulatory agencies such as the SEC, if appropriate.



A review will be made of matters affecting elimination of intercompany transactions and accounts and, if appropriate in the circumstances, the uniformity of accounting practices among the components included in the financial statements.

12.54

If Michaels decides to make reference to the examination of Thomas, Michaels‘s report should indicate the involvement of Thomas as a component auditor. The report should disclose the magnitude of the portion of the financial statements examined by Thomas by stating the dollar amounts or percentages of one or more of the following: total assets, total revenues, or other appropriate criteria, whichever most clearly represents the portion of the financial statements examined by Thomas. Thomas may be named, but only with Thomas‘s express permission and provided Thomas‘s report is presented together Michaels‘ report.

If Michaels does not wish to assume responsibility for Thomas‘ work nor refer to Thomas‘ work and report, Michaels (the group auditor) faces a scope limitation (a portion of the financial statements is essentially unaudited insofar as Michaels is concerned, assuming that Michaels is not able to audit the portion). As a result, Michaels will express either a qualified opinion or disclaimer of opinion.

Various Reporting Situations 1.

Either a qualified opinion or a disclaimer of opinion, depending upon the reason for the scope limitation (client-imposed versus circumstance-imposed) and the degree of materiality and pervasiveness.

If a qualified opinion is issued: 

The Opinion section would be labeled ―Qualified Opinion‖, refer to the scope limitation, and express a qualified opinion



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

If a disclaimer of opinion is issued:



The standard paragraph in the Basis for Opinion section indicating that a GAAS audit was performed is deleted.



Either a qualified opinion or adverse opinion, depending upon degree of materiality and pervasiveness of the GAAP departure.

The report would be modified as follows: 

The Opinion section would be labeled ―Qualified Opinion‖ or ―Adverse Opinion‖, refer to the GAAP departure, and express the appropriate opinion.



In the Opinion section (for an adverse opinion), omit the phrase ―in all material respects‖.



The Basis for Opinion section would be labeled ―Basis for Qualified Opinion‖ or ―Basis for Adverse Opinion‖ and include a paragraph that describes the departure from GAAP and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖ or ―basis for our adverse audit opinion‖.

NOTE: Because the audit team believes a loss should be recorded based on the probable settlement, this represents a departure from GAAP. a.

Either a qualified opinion or adverse opinion, depending upon degree of materiality and pervasiveness of the GAAP departure.

The report would be modified as follows: 

The Opinion section would be labeled ―Qualified Opinion‖ or ―Adverse Opinion‖, refer to the GAAP departure, and express the appropriate opinion.



In the Opinion section (for an adverse opinion), omit the phrase ―in all material respects‖.



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖ or ―basis for our adverse audit opinion‖.

Either a qualified opinion or a disclaimer of opinion, depending upon the degree of materiality and pervasiveness.

If a qualified opinion is issued: 

The Opinion section would be labeled ―Qualified Opinion‖, refer to the scope limitation, and express a qualified opinion



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

If a disclaimer of opinion is issued: 



The standard paragraph in the Basis for Opinion section indicating that a GAAS audit was performed is deleted.



The Responsibilities for the Audit of the Financial Statements section would be modified to note that the audit team was not able to obtain sufficient appropriate

evidence, delete paragraphs describing an audit and required communication with those charged with governance, and include a sentence on requirements for independence and ethical responsibilities. 5.

Unmodified opinion.

Without modifying the paragraphs of the standard (unmodified) report, describe the omitted information in an other-matter paragraph.

Unmodified opinion.

In the Opinion section, indicate that the opinion is ―based on our audits and the report of other auditors‖ and describe the component auditors‘ work. (NOTE: The phrase ―component auditors‖ could be substituted for ―other auditors‖ in the above).

Unmodified opinion.

Without modifying the paragraphs of the standard (unmodified) report, identify the change in accounting principle and refer to the financial statement note discussing this change in principle in an emphasis-of-matter paragraph.

Unmodified opinion.

Without modifying the paragraphs of the standard (unmodified) report, identify the going-concern uncertainty and refer to the financial statement note discussing the goingconcern uncertainty in a section with the heading Substantial Doubt About the Entity’s Ability to Continue as a Going Concern.

NOTE: If the going-concern uncertainty was highly significant, a disclaimer of opinion would be a reporting option in this situation.

12.55

Various Reporting Situations 1.

The Opinion section would only refer to Luck‘s 2020 financial statements. Stanford would include an other-matter paragraph to the report that indicated the 2019 financial statements were audited by other auditors and that an unmodified opinion was issued on those statements.

Stanford would include an emphasis-of-matter paragraph to its report to reference the significant decline in the value of RealCo‘s investment properties. Because this decline has been appropriately recognized by RealCo, it is not a departure from GAAP and an unmodified opinion would still be appropriate in this situation.

If Stanford believed that ―substantial doubt‖ exists about TechTime‘s ability to continue as a going concern, it would include a Substantial Doubt About the Entity’s Ability to Continue as a Going Concern section to disclose this matter. (If these going-concern uncertainties were extremely material and pervasive, a disclaimer of opinion would be a reporting option for Stanford).

Because Stanford has not audited Cardinal, Inc.‘s financial statements, it should issue a disclaimer of opinion. The communication from Cardinal makes it possible that users may misunderstand Stanford‘s level of involvement unless a disclaimer of opinion is issued.

Stanford would issue a separate report to indicate that the summary financial information is fairly stated in relation to the complete financial statements. It is important to note that it would not be 1-345 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

appropriate for Stanford to indicate that the summary financial information is fairly presented according to GAAP. 6.

Stanford should include a separate section (Other Information section) indicating that the verbiage in Plunkett‘s Management Discussion & Analysis section is not consistent with Plunkett‘s financial statements. It is important to note that it would still be appropriate for Stanford to issue an unmodified opinion on Plunkett‘s financial statements, since they are presented in accordance with GAAP.

Stanford should expand its report on Oil Patch‘s financial statements to include an other-matter paragraph that identifies the supplementary information and describes the procedures performed with respect to this information. In addition, Stanford should specifically disclaim an opinion or any form of assurance on the supplementary information. Because the supplementary information was presented in conformity with FASB guidelines and did not appear to depart from GAAP, no additional references should be made to this information.

12.56

Various Reporting Situations 1.

Because the departure is not material, the auditors could issue an unmodified opinion without modifying the standard (unmodified) report or referencing the departure.

Because the audit team was able to perform alternative procedures, a standard report (unmodified opinion) could be issued without any reference to the scope limitation or alternative procedures performed by the audit team. The fact that the scope limitation is circumstance-imposed rather than client-imposed is not relevant with respect to this reporting decision; however, the fact that it is circumstance-imposed does not raise other potentially negative issues associated with clientimposed scope limitations.

Because the audit team does not agree with the rationale for the change in accounting principle, this would be treated as a departure from GAAP and a qualified or adverse opinion would be appropriate. The report would be modified as follows: 

The Opinion section would be labeled ―Qualified Opinion‖ or ―Adverse Opinion‖, refer to the GAAP departure, and express the appropriate opinion.



In the Opinion section (for an adverse opinion), omit the phrase ―in all material respects‖.



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖ or ―basis for our adverse audit opinion‖.

The auditors would issue a one-paragraph disclaimer of opinion indicating that they are not independent with respect to the client.

The auditors would issue an unmodified opinion and include a Substantial Doubt About the Entity’s Ability to Continue as a Going Concern section to disclose this matter. (If these goingconcern uncertainties were extremely serious, a disclaimer of opinion would be a reporting option).

The auditors would issue an unmodified opinion and include an emphasis-of-matter paragraph to the standard (unmodified) report describing the acquisitions.

The auditors would issue an unmodified opinion and modify the Opinion section of the standard (unmodified) report on the group financial statements to indicate the involvement of component auditors.

The auditors could issue either a qualified or adverse opinion, depending upon the materiality of the misstatement and the pervasiveness of its impact on the financial statements. The report would be modified as follows: 

The Opinion section would be labeled ―Qualified Opinion‖ or ―Adverse Opinion‖, refer to the GAAP departure, and express the appropriate opinion.



In the Opinion section (for an adverse opinion), omit the phrase ―in all material respects‖.



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖ or ―basis for our adverse audit opinion‖.

The auditors could issue either a qualified opinion or a disclaimer of opinion, depending upon the materiality and pervasiveness of the accounts impacted by the scope limitation. The report modifications would depend upon the type of opinion selected, as noted below:

Opinion Section

Qualified

Disclaimer

Label section ―Qualified Opinion‖, refer to the scope limitation, and express a qualified opinion

Basis for Opinion Section

Responsibilities for the Audit Section

Label section ―Basis for Qualified Opinion‖

Label section ―Basis for Disclaimer of Opinion‖

Describe scope limitation and its effects (accounts, dollar amounts, percentages, etc.).

Modify phrase ―basis for our audit opinion‖ to ―basis for our qualified audit opinion‖

Delete standard paragraph indicating that a GAAS audit was performed

No modification

Modify first paragraph to note that the audit team was not able to obtain sufficient appropriate evidence Delete paragraphs describing an audit and required communication with those charged with governance Include a sentence on requirements for independence and ethical responsibilities.

12.57

Various Reporting Situations 1.

Because the change is to an accounting principle that is not in accordance with GAAP, the auditors would issue a qualified opinion, since the amount is material but not pervasive. The report would be modified as follows:



The Opinion section would be labeled ―Qualified Opinion‖, refer to the GAAP departure, and express the appropriate opinion.



The Basis for Opinion section would be labeled ―Basis for Qualified Opinion‖ and include a paragraph that describes the departure from GAAP and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

The auditors would issue a qualified opinion and modify the standard report as follows: 

The Opinion section (which would be labeled ―Qualified Opinion‖) would be modified to express a qualified opinion and refer to the scope limitation.



The Basis for Opinion section would be labeled ―Basis for Qualified Opinion‖ and include a paragraph that describes the nature of the scope limitation and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our qualified audit opinion‖.

The auditors would issue a standard (unmodified) report.

The auditors would issue an unmodified opinion and include an emphasis-of-matter paragraph to the standard (unmodified) report describing the change in accounting principles.

The auditors would issue a one-paragraph disclaimer of opinion indicating that they are not independent with respect to the client.

12.58

The auditors would issue an adverse opinion and modify the report as follows: 

The Opinion section would be labeled ―Adverse Opinion‖, refer to the GAAP departure, and express an adverse opinion.



In the Opinion section (for an adverse opinion), omit the phrase ―in all material respects‖.



The Basis for Opinion section would be labeled ―Basis for Adverse Opinion‖ and include a paragraph that describes the departure from GAAP and its effects (accounts, dollar amounts, percentages, etc.).



In the Basis for Opinion section, the phrase ―basis for our audit opinion‖ would be modified to ―basis for our adverse audit opinion‖.

The auditors would issue an unmodified opinion and describe the involvement of component auditors in the Opinion section of the report.

The auditors would issue a separate report on the summary financial statements that would refer to the auditors‘ report on the complete financial statements and indicate whether the summary financial statements are fairly stated in relation to the complete financial statements.

10.

The auditors would issue a disclaimer of opinion and modify the report as follows: 



The standard paragraph in the Basis for Opinion section indicating that a GAAS audit was performed is deleted.



Audit Report Deficiencies 1.

The report needs a title, such as ―Independent Auditor‘s Report‖.

The auditors should address the report to the body that has engaged them (the Continental Corporation Board of Directors). While the report may be read and used by others who are indirect beneficiaries of the audit, it is not appropriate to address the report to the unknown class of users.

The statement of cash flows is not referenced as one of the financial statements audited in the first paragraph of the Opinion section, yet an opinion is expressed on Continental Corporation‘s cash flows.

The last paragraph in the Opinion section should not be modified with the phrase ―with the explanation given below.‖

The last paragraph in the Opinion section should not mention ―minor errors we consider immaterial,‖ but it should contain the phrase ―present fairly in all material respects.‖

The last paragraph in the Opinion section should not refer to pronouncements of the Financial Accounting Standards Board, but to ―accounting principles generally accepted in the United States of America‖.

The report uses inappropriate language in the Basis for Opinion section; instead of referencing ―auditing standards generally accepted in the United States of America‖, it indicates that the audit was performed ―in accordance with instructions by Continental‘s management‖ and that a ―complete audit‖ was conducted, both of which are inappropriate.

The inclusion of the emphasis-of-matter paragraph describing the economy and the strike is questionable. Assuming that its inclusion is appropriate, the reference to negative assurance (concerning the recording of sales) is not appropriate.

The sentence in the Responsibilities for the Audit of the Financial Statements section related to obtaining reasonable assurance about whether the financial statements are free from material misstatement and issuing an opinion is not included.

10.

The date of Ross‘s report should be September 23 (the audit completion date) and not Continental Corporation‘s fiscal year end date (July 31).

12.59

Audit Report Deficiencies: Adverse Opinion Deficiencies in the adverse opinion are: 1.

The report is improperly addressed to the president instead of to the board of directors or others that engaged the audit team.

The Opinion section should be labeled ―Adverse Opinion‖.

The first paragraph of the Opinion section does not identify the specific financial statements audited: balance sheet, statements of income, changes in shareholders‘ equity, and cash flows.

The first paragraph of the Opinion section incorrectly includes information about the audit team‘s responsibility to conduct an audit in accordance with GAAS (this information should be presented in the Basis for Adverse Opinion section).

The conclusion in the second paragraph of the Opinion section that ―the accompanying financial statements, present fairly, in all material respects…‖ is not appropriate for an adverse opinion.

The second paragraph of the Opinion section should refer to the Basis for Adverse Opinion section that provides the basis for the auditors‘ opinion.

The Basis for Adverse Opinion section omits the paragraph referencing generally accepted auditing standards, the requirement to be independent and meet other ethical responsibilities, and the fact that the audit evidence is sufficient and appropriate to provide a basis for the opinion.

The paragraph in the Basis for Adverse Opinion section discussing the departure from GAAP does not refer to the requirements of GAAP (specifically, that property and equipment should be stated at an amount not exceeding historical cost, and deferred income taxes should be provided) or provide the monetary effects of the departure (or an indication that the monetary effects are not reasonably determinable).

The Responsibilities of Management for the Financial Statements section has been omitted.

12.60

Audit Report Deficiencies: Comparative Reporting 1.

The financial statements are not individually identified in the first paragraph of the Opinion section.

While the financial statements have not been individually identified (see [1] above), the description of the time period in the first paragraph of the Opinion section is also inappropriate. For the results of operations, changes in shareholders‘ equity, and cash flows, instead of indicating ―as of‖, the report should indicate ―for the two years ended‖.

The second paragraph of the Opinion section refers only to the current year financial statements, but should refer to both the current year (2020) and the prior year‘s (2019) financial statements presented in comparative form.

The phrase ―based upon the following‖ in the second paragraph of the Opinion section is not appropriate and may be misinterpreted as some sort of qualification or other opinion modification.

The consistency phrase (―consistently applied‖) in the second paragraph of the Opinion section is inappropriate.

The change in method of computing inventory cost should be mentioned in a separate emphasisof-matter paragraph, not in the Opinion section. In addition, this phrase should not use ―except for‖ language, which is reserved for use to qualify an opinion for a GAAP departure or a scope limitation.

The information relating to the updated opinion on the prior year‘s financial statements should be in an other-matter paragraph, not in the Basis for Opinion section.

The type of opinion (adverse) previously issued on the prior year‘s financial statements and date of the auditors‘ report on the prior year‘s financial statements should be identified.

12.61

Audit Report Deficiencies: Audits of Group Financial Statements and Other Operating Matters Opinion Section: 1.

In the second paragraph of the Opinion section, the opinion should not appear to be qualified by use of the phrase ―except for the matter of the report of the component auditors.‖ The proper wording is ―In our opinion, based on our audit and the report of component auditors, the financial statements...‖ (NOTE: The phrase ―other auditors‖ could be substituted for ―component auditors‖ in the report.)

The second paragraph of the Opinion section omits the required reference to accounting principles generally accepted in the United States of America.

The third paragraph of the Opinion section does not disclose the magnitude of the assets and revenues audited by the component auditors.

The third paragraph of the Opinion section disclosed the component auditors‘ name, which is only appropriate if the component auditors‘ report is included with the group auditors‘ report. This report provides no indication that the component auditors‘ report is presented along with the group auditors‘ report.

Basis for Group Financial Statement Opinion Section: 5.

The label ―Basis for Group Financial Statement Opinion‖ is inappropriate (the section should be labeled Basis for Opinion).

The phrase ―with the exception of the matter discussed above‖ is not appropriate, since the involvement of component auditors does not result in a violation of GAAS.

Other-Matter Paragraph: 7.

This paragraph is not appropriate and should be omitted.

Responsibilities of Management for the Financial Statements Section: 8.

The timeframe related to management‘s responsibility to evaluate going concern is one year from the date of the issuance of the financial statements, not the date of the financial statements.

12.62

Audit Report Deficiencies: Disclaimer of Opinion Deficiency

Reason

Correction

The first sentence of the report states that the examination was made in accordance with auditing standards generally accepted in the United States of America.

The examination has not been made in accordance with auditing standards generally accepted in the United States of America because audit teams are required to be independent. This sentence is also inconsistent with the sentence of the report which states that the financial statements were not audited.

Delete the first sentence.

The auditors disclosed the reason for their lack of independence (his wife owns 5% of the stock of the entity).

This disclosure might confuse the reader. For example, the reader may not believe that this investment prevents the audit team from being independent and cause him to place undue reliance on the report and the financial statements. Since independence is a matter of professional judgment, the reader should not be called upon to make this judgment.

Delete the reference to the reason for the lack of independence.

12.63

Audit Report Deficiencies: Accounting Change and Uncertainty Opinion Section: 

In the second paragraph, the phrase ―except for the accounting change, with which we concur‖ should not be used in conjunction with the consistency issue. Related to this, the audit team‘s concurrence with the change in accounting principles is implicit and should not be mentioned.



In the second paragraph, reference to and opinion on the 2019 financial statements is omitted.



The change in computing depreciation in fiscal 2020 should not be included in the Opinion section, but in an emphasis-of-matter paragraph.

Basis for Opinion Section: 

The phrase ―basis for determining whether any material modifications should be made to the financial statements‖ is inappropriate; it should be ―basis for our audit opinion‖.

Emphasis-of-Matter Paragraph: 

The fact that the outcome of the lawsuit cannot presently be estimated is omitted.



It is inappropriate to state that ―provision for any liability is subject to adjudication‖ because the report is ambiguous as to whether a liability has been recorded.

Responsibilities of Management for the Financial Statements Section: 

In the first paragraph, the phrase ―in accordance with accounting principles generally accepted in the United States of America‖ is omitted.

Responsibilities for the Audit of the Financial Statements Section: 

In the first paragraph, the objective regarding reasonable assurance should reference the financial statements being ―free of material misstatement,‖ not ―fairly presented.‖



In the first paragraph, the phrase mentioning the audit team‘s responsibility to express an opinion is omitted.

SOLUTIONS TO REPORT WRITING CASES 12.64

Financial Difficulty: The ―Going-Concern‖ Problem a.

Unmodified Opinion Independent Auditor’s Report

To the Board of Directors and Shareholders Pitts Company Report on the Audit of the Financial Statements Opinion We have audited the financial statements of Pitts Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of Pitts Company as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Opinion We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Substantial Doubt About the Entity’s Ability to Continue in Existence The accompanying financial statements have been prepared assuming that Pitts Company will continue as a going concern. As shown in the financial statements, Pitts Company has current liabilities that exceed current assets by $1 million. Cash balances have been drawn down to $10,000, and the interest on the long term debt has not been paid. As explained in Note 3 to the financial statements, a customer has sued for $500,000 on a product liability claim. Based on these factors, along with other matters discussed in Note 3, Pitts has stated that substantial doubt exists about its ability to continue as a going concern. The financial statements do not include any adjustments relating to these uncertainties. Our opinion is not modified with respect to this matter.

Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements. Auditor’s Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor‘s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users made on the basis of these financial statements. In performing an audit in accordance with GAAS, we: • Exercise professional judgment and maintain professional skepticism throughout the audit. • Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. • Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of ABC Company‘s internal control. Accordingly, no such opinion is expressed. • Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements. • Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for a reasonable period of time. We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control–related matters that we identified during the audit. Anderson, Olds, & Watershed Philadelphia, PA February 10, 2021

Disclaimer of Opinion NOTE TO INSTRUCTOR: Unlike disclaimers related to scope limitations, a GAAS audit has been conducted in this scenario. Accordingly, the modifications to the first paragraph in the Opinion section, the deletion of the paragraph relating to a GAAS audit in the Basis for Opinion section, and the deletion of language in the Auditor’s Responsibilities for the Audit of the Financial Statements section are not applicable. Independent Auditor’s Report

To the Board of Directors and Shareholders Pitts Company Report on the Audit of the Financial Statements Disclaimer of Opinion We have audited the financial statements of Pitts Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. Because of the possible material effect on the financial statements of the matters described in the Substantial Doubt About the Entity‘s Ability to Continue in Existence section of our report, we cannot and do not express an opinion on the accompanying financial statements. Basis for Disclaimer of Opinion We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Substantial Doubt About the Entity’s Ability to Continue in Existence The accompanying financial statements have been prepared assuming that Pitts Company will continue as a going concern. As shown in the financial statements, Pitts Company has current liabilities that exceed current assets by $1 million. Cash balances have been drawn down to $10,000, and the interest on the long term debt has not been paid. As explained in Note 3 to the financial statements, a customer has sued for $500,000 on a product liability claim. Based on these factors, along with other matters discussed in Note 3, Pitts has stated that substantial doubt exists about its ability to continue as a going concern. The financial statements do not include any adjustments relating to these uncertainties.

12.65

Disagreement with Auditors NOTE TO INSTRUCTOR: The following report assumes that the audit team has decided to resign from the engagement and that the threatened litigation has impaired AOW’s independence. One additional option for the following report would be including some disclosure of the litigation that has resulted in the audit team’s resignation if AOW feels that the failure to disclose this litigation would result in the financial statements not being in accordance with GAAP. To the Board of Directors and Stockholders Richnow Company We are not independent with respect to Richnow Company, and the accompanying balance sheet as of December 31, 2020, and the related statements of income, changes in shareholders‘ equity, and cash flows for the year then ended were not audited by us and, accordingly, we do not express an opinion on them. Anderson, Olds, & Watershed Philadelphia, PA February 10, 2021

12.66

Late Appointment of the Audit Team NOTE TO INSTRUCTOR: Depending upon the degree of materiality of the amounts involved and the level of pervasiveness, the auditors should describe the limitation on the examination in an additional paragraph and either qualify the opinion or disclaim an opinion. The following opinion is an example of a qualified opinion. Independent Auditor’s Report To the Board of Directors and Shareholders Musgrave Company Report on the Audit of the Financial Statements Qualified Opinion We have audited the financial statements of Musgrave Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of Musgrave Company as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Qualified Opinion We were unable to perform a physical observation of the inventory carried in the accounts in the amount of $194,000, which is approximately 39% of total assets and approximately 69% of current assets. The inventory enters into the determination of cost of goods sold and net income to a significant extent. Musgrave Company determines inventory quantities and, hence, inventory valuations, solely by means of physical count. Consequently, we were unable to determine whether any adjustments to these amounts were necessary. We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements.

Auditor’s Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor‘s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users made on the basis of these financial statements. In performing an audit in accordance with GAAS, we: • Exercise professional judgment and maintain professional skepticism throughout the audit. • Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. • Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of ABC Company‘s internal control. Accordingly, no such opinion is expressed. • Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements. • Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for a reasonable period of time. We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control–related matters that we identified during the audit. Anderson, Olds, & Watershed Philadelphia, PA February 10, 2021

12.67

Audits of Group Financial Statements Independent Auditor's Report To the Board of Directors and Shareholders Ferguson Company Report on the Audit of the Financial Statements Opinion We have audited the financial statements of Ferguson Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, based on our audit and the report of other auditors, the accompanying financial statements present fairly, in all material respects, the financial position of Ferguson Company as of December 31, 2020, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. We did not examine the financial statements of certain subsidiaries, which statements reflect total assets and revenues constituting 29 percent and 36 percent, respectively, of the related totals. These statements were examined by other auditors whose reports have been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for these subsidiaries, is based solely on the reports of the other auditors. Basis for Opinion We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements.

12.68

Other Information in a Financial Review Section of an Annual Report a.

The financial review section contains statements inconsistent with the audited financial statements. This case does not address the materiality of the inconsistency. Calculations: Current Year

Prior Year $360,000

Incremental

Operating income

$400,000

$ 40,000

Extraordinary gain (realization of tax benefits)

100,000

Interest expense

(81,250)

(60,000)

(21,250)

Income taxes

(127,500)

(120,000)

( 7,500)

Net Income

$291,250

$180,000

$111,250

Ratio of operating income to interest expense

4.92: 1

6.00: 1

1.88: 1

Ratio including extraordinary gain in numerator

6.15: 1

6.00: 1

6.59: 1

100,000

Notice that the officers have managed to find the combination of numbers that produces the highest (most favorable) ratio in the current year. They compared the ratio of operating income to interest expense for the previous year to that same ratio on an incremental basis. While the calculations are correct, a more appropriate comparison would be to compare the current year‘s ratio (excluding the extraordinary gain) to that for the prior year. b.

Other Information Section Management is responsible for the other information on page xx included in the annual report. The other information comprises a financial review but does not include the financial statements and our auditor‘s report thereon. Our opinion on the financial statements does not cover the other information, and we do not express an opinion or any form of assurance thereon. In connection with our audit of the financial statements, our responsibility is to read the other information and consider whether a material inconsistency exists between the other information and the financial statements, or the other information otherwise appears to be materially misstated. If, based on the work performed, we conclude that an uncorrected material misstatement of the other information exists, we are required to describe it in our report. As described below, we have concluded that such an uncorrected material misstatement of the other information exists. The financial review contains a statement to the effect that, on an incremental basis, operating income coverage of interest expense increased to a ratio of 6.59 to 1. We believe this relationship is inconsistent with the audited financial statements. The ratio of operating income (before extraordinary gains, interest expense and income taxes) to interest expense was 6 to 1 in the prior year and 4.92 to 1 in the current year. On an incremental basis, operating income increased $40,000, and interest expense increased $21,250, a ratio of 1.88 to 1. When the extraordinary gain is included for the current year, the ratio of operating income to interest expense is 6.15 to 1 in the current year, 6 to 1 in the prior year, and 6.59 to 1 on an incremental basis.

12.69

Departures from GAAP a.

Report qualified for departure from GAAP Independent Auditor's Report

To the Board of Directors and Shareholders Graham Company Report on the Audit of the Financial Statements Qualified Opinion We have audited the financial statements of Graham Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of Graham Company as of December 31, 2020 and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Qualified Opinion As explained in Note 1 to the financial statements, Graham Company reports its investment in land at appraisal value, and reports the amount in excess of cost in a stockholder equity account entitled ―Current value increment.‖ In our opinion, generally accepted accounting principles do not permit reporting appraisal values in financial statements that purport to show financial position and results of operations in accordance with generally accepted accounting principles. If the cost of the land were reported in the financial statements, total assets would be $400,000 (8%) lower, and shareholders‘ equity would also be $400,000 (11%) lower. We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements.

Adverse opinion for departure from GAAP Independent Auditor's Report

To the Board of Directors and Shareholders Graham Company Report on the Audit of the Financial Statements Adverse Opinion We have audited the financial statements of Graham Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report, the accompanying financial statements do not present fairly the financial position of Graham Company as of December 31, 2020 and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Adverse Opinion As explained in Note 1 to the financial statements, Graham Company reports its investment in land at appraisal value, and reports the amount in excess of cost in a stockholder equity account entitled ―Current value increment.‖ In our opinion, generally accepted accounting principles do not permit reporting appraisal values in financial statements that purport to show financial position and results of operations in accordance with generally accepted accounting principles. If the cost of the land were reported in the financial statements, total assets would be $400,000 (8%) lower, and shareholders‘ equity would also be $400,000 (11%) lower. We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our adverse audit opinion. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements.

12.70

Reporting on an Accounting Change a.

Reporting on an accounting change with which the audit team concurs. Independent Auditor's Report

To the Board of Directors and Shareholders Williams Company Report on the Audit of the Financial Statements Opinion We have audited the financial statements of Williams Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of Williams Company as of December 31, 2020 and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Opinion We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Emphasis of Matter As described in Note 2 to the financial statements, Williams Company changed its accounting principles from the last-in first-out method to the first-in first-out method for the year ended December 31, 2020. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements.

Reporting on an accounting change the audit team thinks is not reported or disclosed in accordance with generally accepted accounting principles (in this case, ASC 250) . Independent Auditor's Report

To the Board of Directors and Shareholders Williams Company Report on the Audit of the Financial Statements Qualified Opinion We have audited the financial statements of Williams Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of Williams Company as of December 31, 2020 and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Basis for Qualified Opinion As disclosed in Note 2 to the financial statements, Williams Company has adopted the FIFO method of accounting for the cost of inventory and goods sold, whereas it previously used the LIFO method. Although the FIFO method is in accordance with generally accepted accounting principles, in our opinion Williams Company has not provided reasonable justification, in this period of rising prices, for making a change as required by ASC 250 “Accounting Changes and Error Corrections.” Inventories that would have been reported at $1.5 million (LIFO) are reported at $1.9 million (FIFO); operating income before tax that would have been $130,000 is reported at $530,000. As a result of this change, current assets, total assets, and shareholders‘ equity are increased by 17, 9, and 14 percent, respectively. We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for one year following the issuance of the financial statements. Auditor’s Responsibilities for the Audit of the Financial Statements 1-374 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor‘s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users made on the basis of these financial statements. In performing an audit in accordance with GAAS, we: • Exercise professional judgment and maintain professional skepticism throughout the audit. • Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. • Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of ABC Company‘s internal control. Accordingly, no such opinion is expressed. • Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements. • Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about ABC Company‘s ability to continue as a going concern for a reasonable period of time. We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control–related matters that we identified during the audit. Anderson, Olds, & Watershed Philadelphia, PA February 10, 2021

APPENDIX 12.A SOLUTIONS FOR REVIEW CHECKPOINTS 12A.1

The major contents of the PCAOB report for the audit of the financial statements of issuers are:       

12A.2

The financial statements and years examined by the audit team. The auditors‘ opinion on the financial statements. A reference to the auditors‘ opinion on internal control over financial reporting. The responsibilities of management and the audit team in the audit of financial statements. An indication that the firm is registered with the PCAOB and meets the independence requirements of the SEC and PCAOB. A description of the audit and an indication that the audit provides a reasonable basis for the opinion. A summary of any critical audit matters identified during the audit engagement.

Critical audit matters are those issues communicated or required to be communicated to the audit committee that involve challenging, subjective, or complex audit team judgment relating to material accounts and disclosures. The audit team is responsible for communicating the following with respect to critical audit matters:   

12A.3

The considerations that led the audit team to identify the critical audit matter The manner in which the critical audit matter was addressed in the audit The relevant financial statement accounts or disclosures that relate to the critical audit matter

An internal control deficiency is a situation in which the design or operation of the control does not allow the entity‘s management or employees to detect or prevent misstatements in a timely fashion. A significant deficiency is a deficiency or combination of deficiencies less severe than a material weakness but important enough to merit attention to those changed with governance. A material weakness is a deficiency, or combination of deficiencies, that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis. Auditors are required to report material weaknesses in their reports on ICFR.

12A.4

When reporting on the financial statements and ICFR in the audit of issuers, auditors may either prepare two separate reports or a single, combined report (known as an integrated report). If separate reports are prepared, each report must contain a reference to the other report.

12A.5

The major contents of the auditors‘ report on ICFR are:   

The opinion on ICFR, along with a reference to the auditors‘ opinion and report on the financial statements. Management‘s and the audit team‘s responsibility for ICFR. A definition of ICFR and the inherent limitations of ICFR.

12A.6

The situations that would result in modifying the report on ICFR are:   

If a material weakness in ICFR is identified, an adverse opinion on ICFR would be expressed. If a scope limitation is encountered in the examination of ICFR, a disclaimer of opinion would be expressed. If component auditors examine the ICFR of a significant subsidiary of a consolidated issuer, an unqualified opinion may still be issued on ICFR, which refers to the report of the component auditors.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 12A.7

12A.8

12A.9

a. b. c.

Incorrect Incorrect Correct

Incorrect

NOTE TO INSTRUCTOR: Because this question asks students to identify which report would not be appropriate, the item labeled “correct” would not be appropriate and those labeled “incorrect” would be appropriate. a. b. c.

Incorrect Incorrect Correct

Incorrect

This is an appropriate report. This is an appropriate report. A disclaimer is used when the audit team‘s scope is limited but not when significant deficiencies exist. This is an appropriate report.

NOTE TO INSTRUCTOR: Because this question asks students to identify which statement is not true, the item labeled “correct” would not be true and those labeled “incorrect” would be true. a.

Correct

b. c. d.

Incorrect Incorrect Incorrect

The report would be dated as of the day that sufficient evidence has been gathered to support the auditors‘ opinion on the effectiveness of the entity‘s ICFR. The report expresses an opinion on the effectiveness of ICFR. An adverse opinion is issued if one or more material weakness(es) exists. The report on ICFR can be presented along with the report on the company‘s financial statements or as a combined report.

12A.10 NOTE TO INSTRUCTOR: Because this question asks students to identify which item is not included in the Basis for Opinion section, the item labeled “correct” would not be included and those labeled “incorrect” would be included. a.

Incorrect

Correct

The responsibilities of the audit team and management in the financial reporting process would be included in the Basis for Opinion section. A broad overview of procedures performed during the audit would be included in the Basis for Opinion section. The requirement for audit teams to be independent with respect to the company would be included in the Basis for Opinion section. The tenure of the auditor would be included along with the signature, date, and location of the audit firm, but not in the Basis for Opinion section.

12A.11 a.

Correct

b. c. d.

Incorrect Incorrect Incorrect

12A.12 a.

Incorrect

Correct

Incorrect

Both the report on the financial statements and the report on ICFR would refer to the one another. The report on ICFR would refer to the report on the financial statements. The report on the financial statements would refer to the report on ICFR. Both the report on the financial statements and the report on ICFR would refer to the one another. An indication that the audit team conducted an audit of the entity‘s financial statements would be included in the Opinion on Internal Control Over Financial Reporting section, not the Basis for Opinion section. The definition of a material weakness in ICFR would be included in a separate section of the auditors‘ report (assuming a material weakness was identified) The responsibilities of the audit team and management for ICFR would be included in the Basis for Opinion section. A reference to the auditors‘ report and opinion on the entity‘s financial statements would be included in the Opinion on Internal Control Over Financial Reporting section, not the Basis for Opinion section.

SOLUTIONS FOR EXERCISES AND PROBLEMS 12A.13 Internet Exercise: Reports on Financial Statements. The following is based on the most recent auditors‘ reports issued prior to publication of the text (based on the most recent report through the first quarter of 2020). Company Date Walmart (WMT) 3/20/2020

ExxonMobil (XOM)

Report on Financial Statements

Report on ICFR

Form of Reports

Auditor

Tenure

Unqualified opinion; mentioned adoption of new accounting standard for leases

Unqualified opinion

Separate

1969

Unqualified opinion

Combined

PwC

1934

Unqualified opinion; mentioned adoption of new accounting standard for investments

Unqualified opinion

Combined

Deloitte

1985

Unqualified opinion

Separate

2009

Unqualified opinion; mentioned adoption of new accounting standard for leases

Unqualified opinion

Separate

1996

2/26/2020 Berkshire Hathaway (BRKA) 2/22/2020

Apple (AAPL) 10/30/2019 Amazon.com (AMZN) 1/30/2020

12A.14 Reports on Internal Control Over Financial Reporting (Report Modifications). a.

This situation would result in an adverse opinion being issued on the effectiveness of the company‘s ICFR. The standard report would be modified as follows:  

Indicate that the entity has not maintained effective ICFR. Include a section that defines a material weakness, identifies any specific material weaknesses noted during the audit, indicates that the material weaknesses were considered in determining the nature, timing, and extent of audit tests, and notes that the report on ICFR does not affect the opinion on the financial statements.

This situation represents a scope limitation; depending on its significance, the auditor could issue a disclaimer of opinion or withdraw from the audit. If a disclaimer of opinion is issued, the standard report would be modified as follows:   

Indicate that an opinion cannot be expressed on the ICFR. Include a description of the scope limitation. Provide the definition of a material weaknesses and identify the specific material weakness whose remediation could not be evaluated.

In this situation, an unqualified opinion would still be appropriate, assuming that the work of component auditors can be relied on and does not indicate the existence of one or more material weakness(es). The report would be modified to refer to the report of the component auditors and indicate that the opinion on ICFR is based, in part, on the report of the component auditors.

This situation would result in an adverse opinion being issued on the effectiveness of the company‘s ICFR. The standard report would be modified as follows:  



12A.15 Reports on Internal Control over Financial Reporting (Identify Report Deficiencies) Opinion on Internal Control Over Financial Reporting Section: 1.

The first sentence should indicate that ―[w]e have audited Van Dyke‘s internal control over financial reporting‖, not ―Management‘s Report on Internal Control over Financial Reporting.‖

The paragraph relating to the audit of the financial statements should reference Sorrell‘s report on the financial statements as well as the date and type of opinion expressed on the financial statements.

Basis for Opinion Section: 3.

The statement indicating Van Dyke‘s responsibility for maintaining effective internal control over financial reporting should also reference Van Dyke‘s responsibility for assessing the effectiveness of internal control over financial reporting.

The statement indicating the auditors‘ responsibility for expressing an opinion on internal control over financial reporting is omitted.

In the final paragraph, the statement that the audit provides a reasonable basis for the opinion on internal control over financial reporting is omitted.

Definition and Limitations of Internal Control Over Financial Reporting Section: 6.

The paragraph discussing inherent limitations of internal control over financial reporting and the risk associated with projecting the effectiveness of internal control over financial reporting to future periods is omitted.

Material Weakness Section: 7.

The definition of a material weakness is omitted.

In addition to identifying the material weaknesses in internal control over financial reporting, the first paragraph should provide some brief information on the nature of the material weaknesses.

The second paragraph discussing the effect of material weaknesses on the nature, timing, and extent of audit tests should explicitly indicate that the report on internal control over financial reporting does not affect Sorrell‘s report on the financial statements.

10.

The paragraph identifying deficiencies in internal control over financial reporting less severe than material weaknesses is inappropriate.

Other: 11.

The report should be dated February 7, 2021, not the date of the financial statements (December 31, 2020.

MODULE A Other Public Accounting Services LEARNING OBJECTIVES 1-381 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Review Checkpoints

Multiple Choice

Exercises and Problems

Explain and provide examples of attestation engagements

1, 2, 3, 4

Identify special reporting considerations involving GAAS audits

5, 6, 7, 8, 9, 10

28, 29, 30, 31, 32 (*)

58, 59, 60, 61, 62, 73 (*)

Identify attestation engagements other than audits and understand the content of reports on those engagements

11, 12, 13, 14, 15, 16, 17, 18, 19, 20

32 (*), 33, 34, 35, 36, 37, 38, 39, 40, 41, 42, 43

63, 64, 65, 66, 73 (*), 74 (*)

Describe review, compilation, and preparation engagements for historical financial information and prepare appropriate reports given specific factual circumstances

21, 22, 23, 24

32 (*), 44, 45, 46, 47, 48, 49, 50, 51, 52, 53

67, 68, 69, 70, 71, 72, 73 (*), 74 (*)

Explain and provide examples of assurance services engagements

25, 26, 27

54, 55, 56

75, 76, 77, 78

(*) indicates that an item corresponds to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS A.1

Attestation engagements provide assurance and report on assertion(s) that are the responsibility of another party. Information that is evaluated in attestation engagements includes historical financial information, financial forecasts and projects, compliance, and controls at service organizations. Accounting and review engagements are engagements less in scope than an audit that are performed on historical financial statements, which is the type of information that is evaluated in an accounting and review engagement. Assurance engagements improve the quality of information for decision makers. Examples of information that is evaluated in an assurance engagement include sustainability reporting, WebTrust services, and SysTrust services.

A.2

Attestation is an engagement in which a practitioner provides assurance on an assertion(s) that is the responsibility of another party. Attestation engagements may be conducted on historical or prospective performance or conditions, physical characteristics, historical events, analyses, systems and processes, or behavior.

A.3

A responsible party is the person who is accountable for the information. It is important that accountants identify responsible parties because their assertion regarding the information serves as the subject of the engagement.

A.4

Examination engagements, review engagements, and agreed-upon procedures engagements differ in terms of the scope of the engagements and the level of assurance provided by the accountants.

A.5

A special purpose framework is an accounting treatment in which substantially all important financial measurements are governed by criteria other than generally accepted accounting principles. Examples of special purpose frameworks include financial statements prepared under regulatory agency accounting rules, tax basis accounting, cash basis accounting, and modified cash basis framework accounting.

A.6

Financial statements prepared using special purpose frameworks may be less expensive to prepare and easier for users to interpret than those prepared under generally accepted accounting principles.

A.7

The major modifications to the auditors‘ report when a non-issuer uses a special purpose framework are:    

A.8

The names of the financial statements should reflect the special purpose framework. The special purpose framework is identified and the report explicitly notes management‘s responsibility for determining that the special purpose framework is acceptable. The report expresses an opinion as it relates to the special purpose framework, rather than GAAP. An emphasis-of-matter paragraph indicates that the financial statements are prepared under a special purpose framework other than GAAP and references disclosures that describe that framework.

When an opinion is expressed on a specified element, account, or item within the financial statements, the report is modified to limit the scope of the audit, responsibility of management, responsibilities of the auditor, and opinion to the specific element, account, or item examined.

A.9

When an auditor examines compliance with contractual agreements or regulatory requirements in conjunction with a GAAS audit of the financial statements, the audit team can issue a separate report on compliance or a combined report that expresses an opinion on the financial statements as well as compliance.

A.10

The information communicated in the auditors‘ report on compliance conducted in conjunction with a GAAS audit includes:    

A statement that a GAAS audit has been conducted An indication that the audit was not directed toward identifying noncompliance and additional procedures might have revealed instances of noncompliance An indication that the audit team is unaware of any instances of noncompliance (if no instances are identified) or an identification of any instances of noncompliance. An indication that the communication on compliance is intended solely for the use of certain parties.

A.11

An engaging party is the entity who establishes the scope of an agreed-upon procedures engagement.

A.12

A report on an agreed-upon procedures engagement:    

Identifies the specified parties and describes the specific procedures performed by the accountant. Notes that an examination was not performed by the accountant and disclaims an opinion. Provides a summary of findings as a result of performing the agreed-upon procedures. If the use of the report is to be restricted, an indication that the report is intended solely for the use of the specified parties and should not be used by person(s) other than those parties.

A.13

A financial forecast is based on expected conditions and courses of action, while a financial projection is based on the occurrence of one of more hypothetical events. Only financial forecasts are appropriate for general use.

A.14

The general contents of an accountants‘ report on an examination of a financial forecast include:     

The financial information examined by the accountants. Management‘s and the accountants‘ responsibility for the financial forecast. An indication that the examination was conducted in accordance with AICPA attestation standards and a brief description of an examination engagement. An opinion on the presentation of the financial forecast and reasonableness of the assumptions. An acknowledgement that differences between forecasted and actual results may occur and may be material.

In addition to the above, the accountants‘ report on a financial projection would (1) identify the hypothetical assumption(s) on which the projection is based and (2) note that the report is not intended to be used by those other than the specified parties. A.15

An agreed-upon procedures engagement provides a list of findings based on the procedures performed. An examination engagement provides an opinion on the financial information and assumptions.

A.16

The two types of engagements that may be performed in a compliance attestation are an examination engagement and an agreed-upon procedures engagement. An examination engagement on compliance expresses an opinion with respect to the entity‘s compliance. An agreed-upon procedures engagement identifies the findings related to the procedures performed by the accountant. 1-384 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

A.17

A compliance report indicates that (1) the broker-dealer maintained effective internal control over compliance, (2) the broker-dealer was in compliance with rules relating to net capital requirements and reserve requirements, and (3) the information used to assess compliance was derived from the brokerdealer‘s records. Accountants may perform examination engagements and express an opinion on compliance reports. An exemption report (1) identifies the provision(s) under which an exemption is claimed by the brokerdealer, (2) indicates that the provision(s) were met during the most recent fiscal year or identifies exceptions from these provisions, and (3) if exceptions were noted, the nature of the exceptions and dates on which the exceptions existed. Accountants may perform review engagements and express limited assurance on exemption reports.

A.18

A user entity auditor conducts the examination of the financial statements of the user organization. If a service organization is involved with processing significant transactions for the user organization, the user entity auditor would utilize the report provided by another auditor (the service entity auditor) to provide assurance on the operating effectiveness of controls implemented at the service organization.

A.19

A service organization is an entity that provides services to user entities that are likely to be relevant to user entities‘ internal control over financial reporting.

A.20

A SOC 1 Type 1 report provides assurance as to only the fairness of the description of the service organization‘s system and the suitability of the design of controls. A SOC 1 Type 2 report provides assurance as to the fairness of the description of the service organization‘s system, the suitability of the design of controls, and the operating effectiveness of the controls. Because audits of issuers require opinions on the effectiveness of internal control over financial reporting, a SOC 1 Type 2 report would be most appropriate for an engagement of an issuer.

A.21

In a review engagement, the accountant:     

Obtains knowledge of the entity‘s business, accounting principles in the entity‘s industry, and the entity‘s organization and operations. Makes inquiries of management. Conducts analytical procedures. Reconciles the financial statements to underlying records. Obtains written representations from management.

In a compilation engagement, the accountant:   

Obtains an understanding of the entity‘s business and applicable accounting principles in the entity‘s industry. Reads the financial statements, looking for obvious clerical or accounting errors. Follows up on information that is incorrect, incomplete, or otherwise unsatisfactory.

In a preparation engagement, the accountant prepares the financial statements using the client‘s records, without performing any additional procedures or issuing a report. A.22

The contents of an accountants‘ review report include:    

An indication that the accountant has reviewed the financial statements. A general description of a review engagement. An indication that a review is substantially less in scope than an audit and a disclaimer of opinion. A statement relating to management‘s responsibility for the financial statements.

 

A statement relating to the accountants‘ responsibility for a review engagement, including a reference to Statements on Standards for Accounting and Review Services. Limited assurance on the fairness of the entity‘s financial statements.

The contents of an accountants‘ compilation report include:    

A statement relating to management‘s responsibility for the fairness of the financial statements. An indication that the accountant has reviewed the financial statements, including a reference to Statements on Standards for Accounting and Review Services. An indication that the accountant did not audit or review the financial statements. A disclaimer of opinion and any form of assurance on the financial statements.

A.23

Limited assurance is a lower form of assurance than an opinion and uses phrases such as ―we are not aware of any material modifications‖ that are necessary for the financial statements to be in conformity with an appropriate financial reporting framework (as opposed to ―the financial statements present fairly‖). Limited assurance is provided because an engagement lesser in scope than a GAAS audit is performed.

A.24

In a preparation engagement, the accountant does not undertake to perform any procedures or issue a report on the financial statements. A compilation involves very limited procedures and the issuance of a compilation report.

A.25

The four areas of assurance services being evaluated by the ASEC are: 1. 2. 3. 4.

A.26

Continuous assurance and continuous controls monitoring: These services involve "real-time" assurance and monitoring of controls as transactions are processed by clients. Audit data standards: These services relate to enhancing the efficiency and effectiveness of audits by standardizing formats of files and fields commonly requested for audits and other purposes. Risk assurance and advisory services: These services relate to advising clients on enterprise risk management processes. Sustainability assurance and advisory services: Services related to sustainability efforts of entities, which involve the combined effects of (1) economic viability, (2) social responsibility, and (3) environmental responsibility.

Sustainability is defined by the AICPA as ―the triple-bottom-line of (1) economic viability, (2) social responsibility, and (3) environmental responsibility.‖ It is becoming increasingly popular for corporations to report on how their operations are beneficial to society and are environmentally responsible. Similar to financial statements, assurance services will add the credibility of a third-party evaluation.

A.27

WebTrust Services provide assurance to consumers on the reliability of Internet websites; SysTrust Services focus on company systems as a means of increasing the reliability of business-to-business computer transactions.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS A.28

A.29

A.30

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement would not be included in an auditors’ report, the item labeled correct would not be included and those labeled incorrect would be included. a.

Incorrect

Correct

Incorrect

Correct

Incorrect

The auditors‘ report would indicate the responsibility of management for the financial statements. The auditors‘ report would identify the financial statements and years examined in the first paragraph of the report (the names of the financial statements may differ under a special purpose framework). The auditors‘ report would not include an opinion on the appropriateness of the special purpose framework (it would include an opinion on whether the financial statements are fairly presented in accordance with the special purpose framework). The auditors‘ report would include a reference to a footnote or other disclosure discussing the special purpose framework. Auditors may limit their substantive procedures to the element, account, or item that is the focus of their engagement. The auditors‘ report on an element, account, or item is appropriate for general use. To express an opinion on an element, account, or item, a GAAS audit must be conducted. Auditors are prohibited from expressing an unmodified opinion on an element, account, or item if they expressed an adverse opinion on the full financial statements. While the Opinion section would be modified to reflect different names of the financial statements, the Auditor’s Responsibility section would not be modified.

A.31

A.32

A.33

Correct

c. d.

Incorrect Incorrect

The Opinion section would be modified to reflect different names of the financial statements, but the Auditor’s Responsibility section would not be modified. The Auditor’s Responsibility section would not be modified. The Opinion section would be modified to reflect different names for the financial statements.

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement is not true, the item labeled correct is not true and those labeled incorrect are true. a.

Incorrect

Correct

Incorrect

Correct

Incorrect

Either a separate or a combined report can be issued with respect to compliance with contractual provisions. The auditors‘ report would express an opinion on the financial statements, but not on compliance with contractual provisions (language such as ―nothing came to our attention…‖ would be used). The use of the report would be limited (ordinarily to management, the board of directors, or a third party). The auditors‘ report would indicate that the audit was not conducted with the purpose of evaluating compliance with contractual provisions (which is why an opinion on compliance cannot be expressed). Auditors may issue compilation reports when they are not independent, as long as their report discloses the lack of independence. Auditors must be independent to conduct an audit examination and issue an opinion on financial statements. Accountants must be independent to conduct an examination engagement and issue an opinion on a financial forecast. Auditors must be independent to conduct an examination and issue a report on the effectiveness of internal control over financial reporting.

NOTE TO INSTRUCTOR: Since this question asks students to identify which procedures are not performed in an attestation engagement on prospective financial information, the item labeled correct is would not be performed and those labeled incorrect would be performed. a.

Incorrect

Correct

Incorrect

Accountants are required to obtain knowledge about the entity‘s business and accounting principles. Accountants are not required to obtain an understanding of the internal controls used to generate prospective financial information. Accountants are required to obtain an understanding of the process through which the prospective financial information was developed. Accountants are required to evaluate the assumptions used to prepare the prospective financial information.

A.34

A.35

A.36

A.37

A.38

A.39

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement is not correct, the item labeled correct is true and those labeled incorrect are true. a.

Incorrect

Correct

Incorrect

a. b.

Incorrect Incorrect

c. d.

Correct Incorrect

Because they provide information about the design and operating effectiveness of internal controls over financial reporting at a user organization, SOC 1 reports would be requested in the audit of issuers. Because they express an opinion on both the design and operating effectiveness of internal control over financial reporting, a Type 2 report (rather than a Type 1 report) would be appropriate. User entities are the entity on whom the audit of the financial statements and internal control over financial reporting are being conducted. SOC 1 reports express opinions on the design (Type 1 and Type 2) and operating effectiveness (Type 2) of internal controls. The report would not indicate that an examination engagement was performed. No reference to a scope limitation or qualification would be provided in a report on an agreed-upon procedures engagement. The report would reference standards established by the AICPA. Limited assurance would be provided in a review engagement; a report on an agreed-upon procedures engagement would provide a summary of findings.

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement would not be included in the accountants’ report, the item labeled correct is not included and those labeled incorrect are included. a.

Incorrect

b. c.

Correct Incorrect

Incorrect

Correct

Incorrect

b. c.

Incorrect Correct

Incorrect

Correct

Incorrect

The report would indicate that the engagement was conducted in accordance with attestation standards established by the AICPA. The report would not reference the achievability of forecasted results. The report would acknowledge that differences may occur between forecasted and actual results. The report would indicate that the accountants have no responsibility to update the report for future events and circumstances. Use of the report would be limited to users who participated in establishing the scope of the engagement. Use of the report would be limited to users who identified the hypothetical assumptions used to prepare the financial projection. A report on an examination of a financial forecast is available for general use, since a forecast is based on expected conditions and courses of action. A report on an examination of a financial forecast is available for general use, since a forecast is based on expected conditions and courses of action. A financial estimate is not a type of prospective financial information covered by Statements on Standards for Attestation Engagements. A financial forecast reflects expected conditions and courses of action. A financial projection assumes the occurrence of one or more hypothetical events. Pro forma financial information is not a type of prospective financial information. A SOC 1 Type 2 report provides assurance with respect to controls placed in operation and the operating effectiveness of controls. In addition to controls placed in operation, a SOC 1 Type 2 report provides assurance with respect to the operating effectiveness of controls. In addition to the operating effectiveness of controls, a SOC 1 Type 2 report provides assurance with respect to controls placed in operation.

Incorrect

A SOC 1 Type 2 report provides assurance with respect to both controls placed in operation and the operating effectiveness of controls.

A.40

a. b. c. d.

Incorrect Correct Incorrect Incorrect

Limited assurance is provided in a review engagement. An agreed-upon procedures engagement provides a summary of findings. An opinion is provided in an examination engagement. An agreed-upon procedures engagement does provide conclusions, in the form of a summary of findings.

A.41

Correct

Incorrect

An accountants‘ report in an agreed-upon procedures engagement will include both a summary of the findings and a summary of the procedures performed. In addition to a summary of the findings, an accountants‘ report in an agreedupon procedures engagement includes a summary of the procedures performed. In addition to a summary of the procedures performed, an accountants‘ report in an agreed-upon procedures engagement includes a summary of the findings. An accountants‘ report in an agreed-upon procedures engagement will include both a summary of the findings and a summary of the procedures performed.

A.42

NOTE TO INSTRUCTOR: Since this question asks which statement would not be included in an accountants’ report, the item labeled correct would not be included and those labeled incorrect would be included. a.

Incorrect

Correct

Incorrect

The accountants‘ report would identify the law, regulation, or other matter that serves as the basis for the engagement. The accountants‘ report would indicate that the engagement was conducted in accordance with AICPA standards (and not generally accepted auditing standards). The accountants‘ report would not provide a legal determination as to compliance. The accountants‘ report would provide a conclusion (either an opinion or a summary of findings) with respect to compliance with the law, regulation, or other matter.

A.43

A.44

A.45

A.46

A.47

NOTE TO INSTRUCTOR: Since this question asks which condition would not be required to be met, the item labeled correct would not be a required condition and those labeled incorrect would be required conditions. a.

Incorrect

Correct

Incorrect

Correct

Incorrect

c. d.

Correct Incorrect

a. b. c.

Incorrect Correct Incorrect

Incorrect

Management must accept responsibility for compliance with the law, regulation, or other matter. Management‘s evaluation of compliance must be evaluated and measured against reasonable criteria. The accountants must gather sufficient evidence to support management‘s evaluation of compliance. Management is not required to provide a report attesting to compliance. While a compilation is lesser in scope than a review, an audit is greater is scope than a review (not lesser in scope). An audit is greater in scope than a review and a compilation is lesser in scope than a review. An audit is greater in scope than a review (not lesser in scope) and a compilation is lesser in scope than a review (not greater in scope). While an audit is greater in scope than a review, a compilation is lesser in scope than a review (not greater in scope). An opinion (and not limited assurance) is expressed in an audit of financial statements. A disclaimer of opinion (and not limited assurance) is expressed in a compilation of financial statements. Limited assurance is expressed in a review of financial statements. An adverse opinion is not a form of limited assurance. SSARS require inquiry about the basis for preparation of the financial statements. SSARS do not require inquiries about internal control deficiencies. SSARS require inquiry about significant transactions occurring near the end of the reporting period. SSARS require inquiry about material subsequent events.

Incorrect

Correct

Incorrect

The accountant‘s report would indicate that a review engagement is substantially less in scope than an audit engagement. The accountant‘s report would indicate that a review engagement was conducted in accordance with SSARS. The accountant‘s report in a review engagement would not refer to a compilation engagement. The accountant‘s report would provide users with limited assurance on the fairness of the financial statements.

A.48

A.49

A.50

A.51

A.52

A.53

Incorrect

Correct

Incorrect

b. c. d.

Incorrect Incorrect Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

Dale‘s report on a review engagement would provide limited assurance, not a disclaimer of opinion. Modifying the scope of the engagement from an audit to a review is appropriate if the reason for the modification is changes in the needs of the client or a misunderstanding about the level of services. Dale is only permitted to modify the scope of the engagement to a review if the reason for the modification is changes in the needs of the client or a misunderstanding about the level of services. Dale could modify the scope of the engagement if the reason for the modification is if the reason for the modification is changes in the needs of the client or a misunderstanding about the level of services. Accountants are not required to be independent in either a compilation or a preparation engagement. Accountants are not required to be independent in a compilation engagement. Accountants are not required to be independent in a preparation engagement. Accountants are not required to be independent in either a compilation or a preparation engagement. The accountants‘ report would indicate that the disclosures are omitted and this omission might affect users‘ conclusions. While the accountants‘ report would indicate that the disclosures are omitted and this omission might affect users‘ conclusions, the accountants would not provide the omitted disclosures in their report. The accountants‘ report would indicate that the disclosures are omitted and this omission might affect users‘ conclusions. Accountants do not express (or disclaim) an opinion in a compilation engagement. The accountant could conduct a compilation engagement, as independence is not required to conduct these engagements. The accountant could conduct a compilation engagement, as independence is not required to conduct these engagements. The accountant could accept the engagement, but must disclose the lack of independence in the report. The accountant could accept the engagement, but would not express limited assurance on the financial statements.

NOTE TO INSTRUCTOR: Since this question asks which statement is not true with respect to a preparation engagement, the item labeled correct is not true and those labeled incorrect are true. a. b.

Incorrect Correct

Incorrect

b. c.

Incorrect Correct

Accountants would obtain an engagement letter in a preparation engagement. The accountants‘ communication to third parties would not refer to independence. The accountants‘ communication to third parties would specifically indicate that no assurance is provided on the financial statements. While not required to do so, accountants could issue a report that disclaims an opinion or any form of assurance on the financial statements. Auditing Standards issued by the PCAOB (and not SSARS) govern engagements involving the audited financial statements of issuers. Issuers are required to have their financial statements audited. SSARS govern engagements involving the unaudited financial statements of nonissuers.

A.54

A.55

A.56

Incorrect

Statements on Auditing Standards issued by the Auditing Standards Board (and not SSARS) govern engagements involving the audited financial statements of non-issuers.

Incorrect

Correct

Incorrect

Accountants must have relevant knowledge to provide assurance services, but knowledge cannot guarantee good conduct of accountants. By maintaining integrity and objectivity, accountants preserve their reputations and competitive advantages in assurance services. While some assurance services relate to accounting and financial matters, accountants may also provide assurance on nonfinancial information. Professionalism and trust help accountants to provide reliable quality assurance services, but these traits are not unique to accountants.

Incorrect

Correct

Incorrect

Correct

Incorrect

Auditing Standards (for issuers) and Statements on Auditing Standards (for nonissuers) provide guidance for expanding auditing services to nonfinancial information. Accounting and review services provide guidance for reviews of unaudited financial information. Assurance services are independent professional services that improve the quality of information or its context for decision makers. Assurance services do not reduce the risk in management decision making. WebTrust provides reasonable assurance that there is adequate system of protection to ensure that the information provided on the website is accurate. An audited annual report does not provide assurance regarding the company‘s website and Internet services. While a money-back guarantee may reduce Harper‘s risk, it will not ensure the accuracy of the website information. While requiring only a partial payment may limit Harper‘s risk, it will not ensure the accuracy of the website information.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS A.57

Attestation Evaluation Criteria One of the most difficult things in an attestation may be establishing the criteria for evaluation. Criteria in this case may include (but are not limited to):         

A.58

How can several schools in the state with similar demographics be used as a benchmark for the school district? How many students graduated as scheduled, and how does this number compare to the number at the benchmark schools? What are the standardized test score trends, and how do they compare to those at the benchmark schools? How many students are attending four-year colleges and universities, and how does this compare to those at the benchmark schools? How many students are attending two-year colleges and how does this compare to those at the benchmark schools? How many students that graduated in the last year are unemployed, and how does this number compare to that at the benchmark schools? Last two years? Last five years? What programs have been established to retain students in school, and how do they compare to programs at the benchmark schools? What programs have been established to prepare students going to college, and how do they compare to programs at the benchmark schools? What programs have been established to help students who are not going to college, and how do they compare to programs at the benchmark schools?

Reporting on a Special Purpose Framework Opinion We have audited the financial statements of Mega Offshore Trust, which comprise the statement of assets and liabilities arising from cash transactions as of December 31, 2020, and the related statement of revenue collected and expenses paid for the year then ended, and the related notes to the financial statements. In our opinion, the financial statements referred to above present fairly, in all material respects, the assets and liabilities arising from cash transactions of Mega Offshore Trust as of December 31, 2020, and its revenue collected and expenses paid during the year then ended in accordance with the cash basis of accounting described in Note 2. Emphasis of Matter - Basis of Accounting We draw attention to Note 2 of the financial statements, which describes the basis of accounting. The financial statements are prepared on the cash basis of accounting, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter.

A.59

Report on Special Purpose Framework Independent Auditor‘s Report To the Board of Directors and Shareholders Brooklyn Life Insurance Company Opinion We have audited the accompanying financial statements of the Brooklyn Life Insurance Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income and cash flows for the year then ended, and the related notes to the financial statements. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Brooklyn Life Insurance Company at December 31, 2020, and results of its operations and cash flows for the year then ended, in accordance with accounting practices prescribed or permitted by the Insurance Department of the State of New York described in Note 10. Basis for Opinion We conducted our audit in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor‘s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of Brooklyn Life Insurance Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Emphasis of Matter — Basis of Accounting We draw attention to Note 10 of the financial statements, which describes the basis of accounting. The financial statements are prepared using the accounting practices prescribed or permitted by the Insurance Department of the State of New York, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter. Responsibilities of Management for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting practices prescribed or permitted by the Insurance Department of the State of New York described in Note 10; this includes determining that this basis of accounting is an acceptable basis for the preparation of the financial statements in the circumstances. Management is also responsible for the design, implementation and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor‘s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements. In performing an audit in accordance with GAAS, we:  Exercise professional judgment and maintain professional skepticism throughout the audit.  Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. 1-395 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.



 

Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of Brooklyn Life Insurance Company‘s internal control. Accordingly, no such opinion is expressed. Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements. Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about Brooklyn Life Insurance Company‘s ability to continue as a going concern for a reasonable period of time.

We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control-related matters that we identified during the audit. Major and Major Associates New York, New York February 20, 2021

A.60

Reporting on a Special Purpose Framework 1. 2. 3. 4. 5. 6. 7. 8.

No (the engagement is still conducted under GAAS) Yes Yes (the opinion would be based on the special purpose framework and not generally accepted accounting principles) Yes No (management is responsible for the appropriateness of the financial framework) Yes Yes No (this type of statement is not included in the auditor‘s report)

A.61

Reporting on Compliance in Conjunction with an Audit Engagement a.

Under generally accepted auditing standards, Prescott is permitted to evaluate compliance with FLSA. When evaluating compliance with FLSA in conjunction with a GAAS audit, Prescott would not perform any additional procedures beyond those related to the audit of the financial statements.

Prescott can either issue a combined report on the financial statements and compliance or separate reports on the financial statements and compliance.

Prescott‘s communication related to compliance should:    

A.62

Indicate that a GAAS audit has been conducted. Either indicate that no instances of noncompliance have been identified or identify any instances of noncompliance (as appropriate) Indicate that the audit was not directed toward identifying noncompliance and additional procedures might have revealed instances of noncompliance. Indicate that use of the report should be restricted to management, the board of directors, and specified users.

Prospective Financial Information 1. 2. 3. 4. 5. 6. 7. 8.

FF B B B FP B N FP

A.63

Prospective Financial Information a.

A financial forecast is based on expected conditions and courses of action, while a financial projection is based on the occurrence of one of more hypothetical events.

Because the financial statements were prepared under one or more assumptions (financing for the acquisition of Sonic Company would be received and the acquisition would be approved by the boards of directors and consummated by March 15, 2021), this information would be a financial projection.

The two types of engagements that can be performed on prospective financial information are examination engagements and agreed-upon procedures engagements. An examination engagement provides an opinion on the prospective financial information and the reasonableness of the assumptions; an agreed-upon procedures engagement provides a summary of findings based on the procedures performed by the accountants.

d. Examination

Agreed-Upon Procedures

Yes

Possibly

Yes

Possibly

Yes

NOTES: 

For (4), if the examination was related to a financial projection, the use of the report would be limited.



For (5) related to agreed-upon procedures, the report would reference procedures on internal control over financial reporting if these were identified as part of the scope of the engagement.

A.64

Review of Forecast Assumptions

Assumption

Evidence Sources and Procedures

1. Sale of real estate

Determine market value of real estate:  Review appraisals (if any); inquire of real estate broker for the selling price of similar pieces of land. Determine cost and tax basis of land:  Examine underlying documents (use financial statement cost presentations, if previously audited), deeds, purchase contracts.  Review Internal Revenue Code and appropriate publications to determine proper tax basis, tax rates, treatment. Determine after-tax profit and proceeds:  Based on the preceding information, compute profit and proceeds.  Compare amounts to client representations to determine reasonableness. Determine authority for use of proceeds:  Examine minutes of directors' and officers' meetings for evidence of authority to sell the real estate and a formal plan for using the proceeds to retire bonds.  Examine debt agreement to ensure it can be prepaid.

2. Retire outstanding debentures

Determine probable cost of repurchasing bonds:  Examine amount, terms of bonds outstanding. Ensure they are callable.  Review current forecasted market for bonds, in light of terms, amount.  Compute estimated cost of repurchase. Determine adequacy of funding for repurchase:  Compare amount of proceeds [computed in (1)] to amount estimated for repurchase. Determine authority for retirement:  Examine minutes of executives‘ and officers' meetings for evidence of approval of retirement.

3. Labor contract

Determine probable wage increase:  Examine prior contract settlements, including subjective analysis of labormanagement relations. Confer with union officials.  Examine documents, memos, and minutes regarding upcoming labor negotiations.  Examine management's proposed contract. Determine effect of higher-than-predicted wage settlement:  Recompute effect of percent change in wage increase to net income and correlate to management's figures.

Assumption

Evidence Sources and Procedures

4. Sales projections

Determine estimated completion date of Portsmouth facility:  Examine contract plans, consult with contractor, and observe facility.  Examine contracts for machinery, installation; consult with vendor as to dates, type of equipment, productive capacity.  Compare the audit team‘s estimated completion date to management's for reasonableness.  Consider whether company can meet personnel requirements of the new facility. Estimate financial impact of Portsmouth production:  Compare productive capacity to forecasted sales figure (presumed determined reasonable by the audit team).  Recompute probable effect of delay in Portsmouth's completion date and compare to management's figures.

A.65

Service Organization Control Reports a.

The user auditor conducts the audit examination of an entity who utilizes a service organization to process transactions (in this instance, SA is the user auditor). The service auditor evaluates controls operating at a service organization and provides a report to the user auditor (in this instance, PM is the service auditor). The user organization is the entity whose financial statements are being audited that utilizes a service organization to process transactions (in this instance, Love is the user organization). The service organization is the entity that processes transactions on behalf of a user organization (in this instance, Worknight is the service organization).

Because Love Company is an issuer and SA must express an opinion on internal control over financial reporting, SA would request a SOC 1 Type 2 report.

The major contents of the SOC 1 Type 2 report on Worknight‘s controls would include:     

A.66

A description of Worknight‘s assertions regarding internal controls PM‘s responsibility to express an opinion on the fairness of the presentation of the description of internal control, suitability of the design of controls, and operating effectiveness of the controls. A summary of the tests of operating effectiveness of controls performed by PM. PM‘s opinion on the fairness of the presentation of the description of internal control, the suitability of design of controls, and operating effectiveness of the controls. A restriction on the use of the report to Worknight, Love, and SA.

Compliance Reporting

Procedures performed in a separate attestation engagement to examine compliance with laws and regulations include:     

Understand the specific compliance requirements and assess planning materiality Plan the engagement and assess inherent risk Understand relevant controls over compliance, assess control risk, and design tests of compliance giving consideration to detection risk Obtain sufficient evidence related to compliance, including written representations from management Consider subsequent information that bears on the management assertion related to compliance and subsequent occurrences of noncompliance after the assertion date

If compliance is evaluated in conjunction with a GAAS audit, the audit team would not perform any of the above procedures related to compliance. They would perform procedures related to the audit of the financial statements, without any specific consideration of matters related to compliance. b.

The major contents of the auditors‘ report on compliance if conducted in conjunction with an audit engagement include the following statements:   

A GAAS audit has been conducted. Either no instances of noncompliance have been identified or identification of any instances of noncompliance (as appropriate) The audit was not directed toward identifying noncompliance and additional procedures might have revealed instances of noncompliance.

If conducted as a separate engagement, the accountants‘ report would:      c.

Indicate that compliance has been examined Indicate the engagement was conducted in accordance with attestation standards established by the AICPA Provide a general description of the requirements of an examination engagement Indicate that the examination does not provide a legal determination with respect to compliance Express an opinion on compliance

When reporting on compliance with laws and regulations in conjunction with an audit engagement, the audit team can either issue a combined report on the financial statements and compliance or separate reports on the financial statements and compliance.

A.67

Accounting and Review Services The contents of the memo and recommendations may vary based on assumptions made by students: To: From: Date: Re:

Dr. Horkheimer Budding CPA January 23, 2021 Available Professional Services

This memo provides a basic summary of professional financial statement services available to you from our firm and provides you with a conclusion for which service would best fit your business. Audit An audit is designed to provide reasonable assurance that financial statements are presented fairly in all material respects in accordance with an applicable financial reporting framework. An audit is the highest scope engagement and requires the greatest level of effort (and, consequently, cost). In addition, the accountant/auditor must be independent in order to express an opinion on the financial statements. Finally, an audit can only be performed if you have prepared an existing set of financial statements. Review A review is substantially less in scope that an audit and is designed to provide limited assurance to the users of the financial statements that any modifications need to be made to the financial statements. As with an audit, the accountant must be independent and a review engagement can only be performed if you have prepared an existing set of financial statements. Compilation A compilation provides no assurance to the users of the financial statements, but does result in a report from the accountant. Unlike an audit or review, the accountant does not need to be independent to conduct a compilation engagement. While a compilation does not provide any assurance, it does reflect some (limited) level of involvement by an accountant. Preparation of Financial Statements This service is the least costly and involves the preparation of financial statements from a client‘s records, without the name of the accountant listed on the financial statements. This service provides a company with properly prepared financial statements, but without any indication that they were prepared or evaluated by an accountant. Recommendation Because you do not currently have financial statements prepared on a regular basis, neither an audit or review would be appropriate at this time. As a first step, you should begin to prepare regular financial statements for potential lenders or new doctors. Either a compilation engagement or a preparation engagement would accomplish this goal for you. An additional advantage of those engagements is that because the accountant need not be independent, we would be available to assist you with financial accounting issues involved in preparing the financial statements. As a result, we would recommend the Preparation engagement as a useful starting point for your organization.

A.68

Errors in an Accountants’ Review Report a.

The prior-year audited financial statements should only be referenced in the last paragraph (other-matter paragraph).

The financial statements are properly identified in the first paragraph of the report.

The AICPA (and Statements on Standards for Accounting and Review Services) should be cited in the third paragraph (Accountant’s Responsibility section) of the report.

The reference to analytical procedures and inquiries in the first paragraph is appropriate.

The review report should compare the scope of a review to an audit in the first paragraph.

Limited assurance should be provided in the fourth paragraph (the Accountant’s Conclusion section).

The disclaimer of opinion should be provided in the last sentence of the first paragraph of the report.

―Accounting principles generally accepted in the United States of America‖ should be referenced in the Management’s Responsibility for the Financial Statements section.

The use of review reports is not restricted, so this reference is inappropriate.

Reference to independence should be included in the Accountant’s Responsibility section.

The type of opinion on the audited financial statements should be identified.

When the current level of service is a review engagement, the report should indicate that no auditing procedures were performed after the date of the report on the prior-year financial statements.

The language relating to responsibility for updating the report is not appropriate.

A.69

Compilation and Review Procedures Required for a review?

Required for a compilation?

The accountants should establish an understanding in writing with the entity‘s management regarding the nature and limitations of the services to be performed.

Yes

The accountants should make inquiries concerning actions taken at the board of directors‘ meetings.

Yes

The accountants, as the entity‘s successor accountants, should communicate with the predecessor accountants to obtain access to the predecessors‘ audit documentation.

The accountants should obtain a level of knowledge of the accounting principles and practices of the entity‘s industry.

Yes

The accountants should obtain an understanding of the entity‘s internal control.

The accountants should perform analytical procedures designed to identify relationships that appear to be unusual.

Yes

The accountants should assess the risk of material misstatement.

The accountants should obtain a letter from the entity‘s attorney to corroborate the information furnished by management concerning litigation.

The accountants should obtain management representations from the entity.

Yes

10.

The accountants should study the relationship of the financial statement elements that would be expected to conform to a predictable pattern.

Yes

A.70

A.71

Limited Assurance in Review Reports a.

Yes, this is an example of limited assurance.

Limited assurance is generally prohibited in audit reports because the profession wishes such reports to contain positive assertions based on evidence instead of negative statements based on "what did not come to my attention."

A review service is less in scope than an audit. As a result, the report can provide lower levels of assurance than that provided in an audit engagement. In some cases, financial statement users may be satisfied with the lower levels of assurance provided by a review engagement.

Prepare a Compilation Report Accountant’s Compilation Report Mr. James Coffin Coffin Auto Speed Shop Management is responsible for the accompanying financial statements of Coffin Auto Speed Shop, which comprise the balance sheets as of June 30, 2021 and the related statements of income and cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. I have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. I did not audit or review the financial statements nor was I required to perform any procedures to verify the accuracy or completeness of the information provided by management. I do not express an opinion, a conclusion, nor provide any assurance on these financial statements. Management has elected to omit substantially all the disclosures ordinarily included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America. If the omitted disclosures were included in the financial statements, they might influence the user‘s conclusions about the company‘s assets, liabilities, equity, revenue, and expenses. Accordingly, the financial statements are not designed for those who are not informed about such matters. /s/ Student Compiler Certified Public Accountant July 15, 2021

A.72

Reporting on Comparative Unaudited Financial Statements Independent Accountant‘s Review Report To the Directors of Independence Company I have reviewed the accompanying financial statements of Independence Company, which comprise the balance sheet as of December 31, 2020, and the related statements of income, changes in stockholders‘ equity, and cash flows for the year then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management‘s financial data and making inquiries of company management. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statements as a whole. Accordingly, I do not express such an opinion. The financial statements of Independence Company as of and for the year ended December 31, 2019, were compiled by other accountants whose report dated February 1, 2020, stated that they have not audited or reviewed the 2019 financial statements and, accordingly, do not express an opinion or provide any assurance about whether the financial statements are in accordance with accounting principles generally accepted in the United States of America. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement whether due to fraud or error. Accountant’s Responsibility My responsibility is to conduct the review engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. Those standards require me to perform procedures to obtain limited assurance as a basis for reporting whether I am aware of any material modifications that should be made to the financial statements for them to be in accordance with accounting principles generally accepted in the United States of America. I believe that the results of my procedures provide a reasonable basis for my conclusion. Accountant’s Conclusion Based on my review, I am not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with accounting principles generally accepted in the United States of America. Anson Jones, CPA San Antonio, TX January 15, 2021 Assumptions needed to write the report:

A.73

    1. 2. 3. 4. 5. 6.

Jones is independent and can conduct the review engagement. Able Associates made no modifications in its 2019 compilation report. Able Associates was independent. The 2019 statements contained all necessary disclosures. SAS, SSAE, PCAOB, SSARS SSAE SAS SSAE SSAE PCAOB

7. 8. 9. 10.

SAS SSAE SSAE, SSARS SAS

A.74 E

Yes

Possibly

Yes

Possibly

Yes

10.

Yes

Possibly

A.75

Assurance Services a.

A.76

Reasons for Johnson‘s concerns include the fact that customers may be reluctant to purchase baseball cards from Davis‘s website for the following reasons. 

Customers have never heard of Davis‘s company, so they are concerned whether it is authentic.



Even if they believe that the company is authentic, customers do not know whether it is trustworthy because the customer has no business practice history with the company.



Customers may doubt whether the website is technically and financially supported to ensure that customers‘ personal information is secured.

Davis and Johnson may take the following steps to reduce customers‘ reluctance to purchase on the Internet. First, Davis and Johnson should consider the customers‘ concerns when they design the website. Secondly, they can develop a system that will effectively process transactions and protect customers‘ privacy at the same time. Then they can pursue a CPA WebTrust seal. By providing such a seal on their website, they clearly convey the information that accountants have provided reasonable assurance for their website and Internet services. Therefore, by gaining the WebTrust assurance, Davis will increase customers‘ confidence in his website and win more business.

Assurance Services a.

The advantages for Henry are: 

Timely supply of inventories. If the supplier has access to the inventory file and is permitted to automatically ship an established amount of product that is under the reorder point, the store will be refilled with adequate inventory right before specific items are out of stock.



Reduced reorder cost. This arrangement shifts the burden of reordering to the supplier. The supplier needs to keep an eye on Henry‘s inventory record and ship items Henry needs. Henry thus avoids incurring the cost to count his own inventory and place an order.



Reinforcement of the relationship with the supplier. This arrangement interrelates the sales performance of Henry‘s store to the supplier‘s business, thus encouraging both parties to be more cooperative.

The advantages for A-Plus Vitamins are: 

First-hand information of customer’s inventory. Whenever Henry‘s inventory is short, APlus Vitamins knows simultaneously and can make a decision about replacement instantly.



Reduced selling cost. The sale is automatically generated after Henry‘s inventory record indicates a short of specific items. It is not necessary for A-Plus Vitamins sales representatives to contact Henry and sell items.



Important market information for manufacturing. By analyzing Henry‘s inventory information, A-Plus Vitamins can keep track of consumers‘ taste, thus manufacturing products according consumers‘ requirements. At the same time, products in stock may

decline in a pattern according to the sales performance of Henry‘s store. Therefore, the manufacturing at A-Plus Vitamins may be adjusted to the pattern. b.

Henry‘s concerns concerning this arrangement are as follows. 

System security. A-Plus Vitamins is permitted access only to the inventory file, not other files. Henry must ensure that A-Plus cannot access other computerized files. Henry needs to be assured that only authorized employees have access his computer system through A-Plus‘ computer system.



Confidentiality. Because the system is connected to the supplier, it is critical to make sure that the inventory information is safeguarded from unauthorized users.



Availability of the supplier. Henry needs to be concerned that the supplier is appropriately reviewing the inventory.



Proper process. It is very important for Henry‘s store to receive the correct items that are short.

Henry‘s concerns can be addressed if A-Plus Vitamins asks for the SysTrust assurance. SysTrust Service is used as a means of increasing the reliability of business-to-business transactions. SysTrust practitioners will provide opinions on the issues that concern Henry after they examine the system.

A.77

Internet Assignment: Global Reporting NOTE TO INSTRUCTOR: The following represents the top-specific standard disclosures and subcategories as of June 1, 2019. It is likely that these disclosures and subcategories will change over time. a.

Economic:  Economic Performance  Market Presence  Indirect Economic Impacts  Procurement Practices  Anti-corruption  Anti-competitive behavior Environmental:  Materials  Energy  Water and Effluents  Biodiversity  Emissions  Effluents and Waste  Environmental Compliance  Supplier Environmental Assessment Social:  Employment  Labor/Management Relations  Occupational Health and Safety  Training and Education  Diversity and Equal Opportunity  Non-discrimination  Freedom of Association and Collective Bargaining  Child Labor  Forced or Compulsory Labor  Security Practices  Rights of Indigenous Peoples  Human Rights Assessment  Local Communities  Supplier Social Assessment  Public Policy  Customer Health and Safety  Marketing and Labeling  Customer Privacy  Socioeconomic Compliance

Many of the above subcategories are associated with quantitative measures (financial impacts, environmental discharges, etc.) while others are policy-related. To the extent that companies provide reports on these measures to shareholders and others, accountants can provide assurance on the validity of their claims. As just one example, if a company reports that its operations meet occupational health and safety standards, accountants can determine whether any violations or these standards have occurred over a period of time.

MODULE B Professional Ethics LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

1, 2

Exercises, Problems, and Simulations 54

1. Understand general ethics and a series of steps for making ethical decisions. 3, 4

5, 6

21, 30

7, 8, 9, 10, 11

18, 19, 22, 23, 25, 26, 27, 29, 34, 41

12, 13, 14, 15

24, 28, 31, 32, 33, 35, 36, 37, 38, 40, 42, 43, 44

16, 17

55, 56, 57

2. Reason through an ethical decision problem using the imperative, utilitarian and virtue theories of moral philosophy.

3. Identify the different entities that make ethics rules for CPAs and public accounting firms.

4. With reference to American Institute of Certified Public Accounting (AICPA), Government Accountability Office (GAO), Public Company Accounting Oversight Board (PCAOB), and Securities and Exchange Commission (SEC) rules, analyze factual situations and decide whether an accountant‘s conduct does or does not impair independence.

5. With reference to AICPA rules on topics other than independence, analyze factual situations and decide whether an accountant's conduct does or does not conform to the AICPA Code of Professional Conduct.

45, 46, 47, 48, 53, 59, 62, 63, 64, 65

49, 50, 51, 52, 58, 61

59, 60, 61

6. Explain the types of penalties that can be imposed on accountants.

A note to instructors about Module B, relating to the "Generalization Argument": In the interest of fairness, it should be noted that the generalization argument does not work in all cases, particularly in two circumstances: (1) When the argument is invertible, that is (a) when both doing something and not doing something would be undesirable and (b) when both everyone and not everyone doing something would be undesirable. For example: "What if everyone was a full-time farmer?" The results would be undesirable in our society because all other social functions would disappear, but this cannot mean that no one should be a farmer because then we would all starve. (2) When the argument is reiterable, that is, when arbitrary times, places, or measures can be inserted in such a way as to make a decision appear to be nonsense. For example, "What if every auditor was permitted to own 1/10 of a share of each client's common stock? Presumably, the consequences of such minor holdings would not be generally undesirable, and so ownership of 1/10 of a share could be permitted. Now change the amount to 1 share, 5 shares or 100 shares. How about 1,000 shares? One can see that ultimately the problem becomes one of "where to draw the line."

SOLUTIONS FOR REVIEW CHECKPOINTS B.1

A professional accountant must be prepared to be an agent, a spectator, an advisor, an instructor, a monitor, a judge, and a critic. Overall, the primary goal as a professional is to employ a consistent process for making ethical decisions. Consequently, an understanding of some of the general principles of ethics can provide background for a detailed consideration of standards for professional conduct. As a professional, you will face choices that necessitate reflective thinking . This involves engaging in an important sequence of events beginning with the recognition of a decision problem. In the ethics context, collection of evidence refers to thinking about rules of behavior and outcomes of alternative actions. The process ends with analyzing the situation and taking an action. Ethical decision problems almost always involve projecting yourself into the future to live with your decisions. Professional ethics decisions usually turn on these questions: ―What written and unwritten rules govern my behavior?‖ and ―What are the possible consequences of my choices—whom will my decision affect?‖

B.2

Conscience might not be a sufficient guide for a. Personal ethics decisions because the individual's indefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. b. Exactly the same can be said about professional ethics decisions because a non-hypocritical individual can no more split her or his behavior between personal life and professional life than she or he can voluntarily split her or his own personality.

B.3

a. The rule "failure to tell the truth is wrong" would require that the staff accountant (1) refuse to "enhance" the financial statements and (2) not to worry about the consequences that seem to be predicted. (They might not turn out bad anyway if the company can get the loan honestly or can find another lender or can develop other means of survival.) b. This rule may be called imperative because it requires the truth regardless of what you might personally feel about the consequences. Strict imperative theory (e.g., Kant) excuses the individual from responsibility for undesirable consequences as long as the decisions do not cause other people to be used as the means.

B.4

Utilitarian ethics theory requires a decision maker to recognize the value attributes of the consequences of ethical choice alternatives (good v. evil), somehow measure or weigh these, and then decide on the basis of the greater good (or the lesser evil). Imperative ethics does not require that consequences be considered.

B.5

The AICPA PEEC makes independence rules applicable to CPAs who (1) are members of AICPA (not all CPAs are members) and (2) perform audits of financial statements (of both public companies and private entities).

B.6

b., c.

The SEC and PCAOB make independence rules applicable to (1) all accountants (most are CPAs, but the law doesn‘t specify CPAs) who (2) perform audits of public companies (only of public companies that file financial statements with SEC, not all other audits).

The IFAC makes independence rules applicable to CPAs who perform audits of multinational companies. When faced with a choice between the AICPA code and the IFAC code, the CPA should always comply with the more restrictive of the standards that is applicable given the facts and circumstances.

Rules of conduct for a. Practicing public accounting come from:  State boards of accountancy.  American Institute of CPAs.  International Federation of Accountants.  State societies of CPAs.  Public Company Accounting Oversight Board.  General Accounting Office. b.

Practicing internal auditing:  The Institute of Internal Auditors (IIA) (1). Standards for the Professional Practice of Internal Auditing. (2) The Institute of Internal Auditors Code of Ethics.

Practicing management accounting:  Institute of Management Accountants (IMA).  Standards of Ethical Conduct for Management Accountants.

Practicing fraud examiners:  The National Association of Certified Fraud Examiners.

B.7

The intent of this question is to require students to study the SEC definitions. Yolanda is in the chain of command (item 3–person who evaluates performance or recommends compensation of Javier, the audit engagement partner of Besame) a. Because Yolanda is a covered person in the firm, independence is impaired when she owns Besame stock. b. Independence is not impaired when her close relative (brother) owns a small number of shares.

B.8

No, audit independence is impaired when the audit firm‘s employees render legal services of this type.

B.9

The SEC believes that people who use financial statements and auditors‘ reports can be enlightened with information about auditors‘ fee arrangements with clients. (The ―enlightenment‖ involves users‘ perceptions of auditor independence regarding the relation of nonaudit and audit revenues from an audit client.) What must be disclosed are (1) total audit fees, (2) total fees to the audit firm for consulting services on the design and implementation of financial information systems, and (3) total fees to the audit firm for all other consulting and advisory work (over and above the audit fees and the information systems fees above). In addition, the disclosure rules also require revealing (1) whether the those charged with governance (including the audit committee or the board of directors) considered the audit firm‘s information systems work and other consulting work to be compatible with maintaining auditors‘ independence and (2) whether more than 50 percent of the audit hours were performed by persons other than the principal accountant's full-time, permanent employees (―leased employees‖ in an ―alternative practice structure‖ arrangement).

B.10

Both want to ensure that those charged with governance (including the public company audit clients‘ audit committees and boards of directors) consider their auditors‘ independence in general and in connection with any nonaudit services provided concurrently by the audit firm.

B.11

The threat to independence is that while a member of the audit team, an auditor who considers a job offer from a client might not perform audit work properly. That is, the auditor may have some newfound loyalty to the client and interest in its success. This may impact decision made on the audit.

B.12

Members of the AICPA have ethical responsibilities for acts of nonmembers under their supervision. That is, a member shall not permit others to carry out, on his or her behalf, either with or without compensation, acts that, if carried out by the member, would place him or her in violation of the Rules of Conduct.

B.13

Rules of conduct that apply specifically to AICPA members in government and industry include: The Integrity and Objectivity Rule: Members in government and industry cannot subordinate their judgment to superiors and produce misleading financial statements. Members in government and industry must be candid and not omit information when dealing with external auditors, and not have undisclosed conflicts of interest in their jobs. The Accounting Principles, The Compliance with Standards, and the General Standards Rules: When members in government and industry represent their companies' financial statements as being "in conformity with GAAP," they are expressing an "opinion" that is subject to AICPA Code of Conduct Rules, which require disclosure of any material departure from accounting principles promulgated by a body designated by Council (FASB and GASB). The Acts Discreditable Rule: Participation in the production of false and misleading financial statements is a discreditable act.

B.14

B.15

According to the AICPA, there are rules of conduct related to the form of organizational control: a.

CPAs shall have majority (50 percent or more) ownership and voting rights of a firm.

CPAs must have ultimate responsibility for attest services at the firm.

Non-CPAs cannot be passive investors but must be active in the practice of the firm. Non-CPAs cannot hold themselves out as CPAs. Non-CPAs must abide by the AICPA Code of Professional Conduct. Non-CPAs must have the same educational levels and meet the same continuing education requirements as CPAs.

The primary difference between commissions and referrals is that commissions relate to the sale of products while referrals relate to a fee received by the CPA for services performed by another CPA or that the CPA pays to another CPA firm to obtain a client. The Fees and Other Types of Remuneration Rule of the AICPA Code of Conduct outlines the rules related to commissions and referral fees.

B.16

AICPA and the state societies can impose a number of penalties, including the following:     

B.17

Admonish a violator (which amounts to a slap on the wrist). Suspend the violator's membership. Expel the violator from membership. Require CPE hours to be undertaken by the violator. Publish the violator's name in a report of proceedings (e.g., in CPA Letter and a state society newsletter or magazine

The SEC and the PCAOB can impose penalties, including the following: 1. 2. 3. 4.

Admonish a license holder (which amounts to a slap on the wrist). Revoke or suspend the violator's license to audit public companies. Require additional continuing professional education. Impose a fine on the violator.

In addition, the SEC can deny (temporarily or permanently) the privilege of practice before the SEC with a "Rule 102(e)" proceeding. (The SEC can also "censure" a CPA, which amounts to a slap on the wrist and settle for an injunction in which the CPA promises not to violate the rules of conduct in the future.) In addition, when laws are broken, the SEC can initiate legal proceedings resulting in fines and/or imprisonment.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS B.18

a. b. c. d.

Incorrect Correct Incorrect Incorrect

Independence in fact refers to the facts, not appearances. Since appearances influence the public, this is important. Fundamental principles do not mention independence in appearance. This has nothing to do with independence in appearance.

B.19

a. b.

Incorrect Incorrect

Correct

Incorrect

An external auditor is not able to ―assure‖ that they are independent. Sarbanes-Oxley and PCAOB have placed the responsibility for ensuring that the external auditors are independent on those charged with governance (including the audit committee). Management is not responsible for the auditor‘s independence. Sarbanes-Oxley and PCAOB have placed the responsibility for ensuring that the external auditors are independent on those charged with governance (including the audit committee). The PCAOB sets standards for the auditing profession and serves at the regulator for audit firms. The PCAOB is not responsible for the auditor‘s independence.

a. b.

Correct Incorrect

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

B.20

B.21

Imperative means that a rule is always followed. Utilitarian means that some exceptions based on a calculation of good and bad outcomes is sometimes used. This is the second best answer because strict adherence to rules might be consider a virtue. The firm is following a rule, not listening to members‘ collective conscience. FASB makes accounting principles (not independence rules). GAO makes auditing standards for government audits. The PCAOB (in cooperation with SEC) makes independence rules for auditors of public companies. ARSC makes practice standards for accountants‘ work on unaudited financial statements.

B.22

B.23

B.24

B.25

B.26

a. b.

Incorrect Correct

Incorrect

Correct

Incorrect

b. c.

Correct Incorrect

Correct

a. b.

Incorrect Correct

Incorrect

Correct:

Incorrect

Merely auditing competitors does not impair independence. This statement implies that the auditor subordinated judgment to the client‘s officer. Lack of competence itself is not an impairment of independence. The facts may have been misrepresented, but the auditors didn‘t know it. This example is another example of a lack of competence. In this case, the auditors misrepresented facts (giving the unqualified report when the audit was not entirely in conformity with GAAS), but they did not knowingly do so. Sarbanes-Oxley and the PCAOB have placed the responsibility for auditors‘ independence on the audit committee. However, it would be difficult to monitor whether individual public accounting firm employees are independent. Firm quality control practices monitor this. Sarbanes-Oxley and the PCAOB have placed the responsibility for auditors‘ independence on the audit committee. Primary in this responsibility is the monitoring of all engagements contracted with the external auditors to ensure that the auditors are not performing any assignments that are prohibited by PCAOB standards or otherwise impair the auditors‘ independence. While Sarbanes-Oxley and the PCAOB have placed the responsibility for auditors‘ independence on the audit committee, the audit committee does not have to report to the PCAOB. Sarbanes-Oxley and the PCAOB have placed the responsibility for auditors‘ independence on the audit committee. However, it would be difficult to monitor whether individual public accounting firm employees are independent. Firm quality control practices monitor this. The Independence Rule is focused on members in public practice, not members serving in industry or government. Integrity and objectivity are required of all members. The Confidential Client Information Rule is focused on members in public practice, not members serving in industry or government. Prohibition of discreditable acts applies to all members. This type of bookkeeping service impairs independence. Independence is not impaired for nonfinancial statement–related internal audit services when the client has its own director of internal auditing in charge. Independence is impaired when the audit firm performs more than 40 percent of financial-related internal audit work (i.e., outsourced internal audit work) for all clients with more than $200 million assets. So, this is an incorrect response. Independence is impaired when auditors perform important actuarial work and then audit their own work product (the client‘s actuarial calculations based on the audit team-prepared assumptions). The answer is both (a) and (b). Independence is not impaired in (a). Managers not on the engagement can own shares in nonclient sister funds. The answer is both (a) and (b). Independence is not impaired in (b). Close family members of audit partners can own shares in audit client sister funds not audited by the close family member‘s relatives, so long as the shares are held through the family member‘s employee benefit plan. Independence is not impaired in (a) and is not impaired in (b). So, (c) is the correct answer. Independence is not impaired in (a) and is not impaired in (b). So, (c) is the correct answer.

B.27

a. b. c. d.

Incorrect Incorrect Correct Incorrect

A spouse is defined as an immediate family member. A spousal equivalent is defined as an immediate family member. A parent is defined as a close relative but not an immediate family member. An uncle is neither an immediate family member nor a close relative.

B.28

a. b.

Incorrect Incorrect

Incorrect

Correct

The audit organization may not reduce the scope of its audit. There are restrictions concerning where in the organization the nonaudit work can be performed. The audit organization, not the government organization, must document why the nonaudit service does not affect independence. The scope of the audit work cannot be reduced because a public accounting firm performed it.

Incorrect

Correct

B.30

a. b. c. d.

Incorrect Incorrect Incorrect Correct

The Accounting and Review Services Committee has been so authorized. The Accounting and Review Services Committee has been so authorized. The Accounting and Review Services Committee has been so authorized. The Accounting and Review Services Committee has been so authorized.

B.31

a. b. c. d.

Incorrect Correct Incorrect Incorrect

The Federal Accounting Standards Advisory Board has been so authorized. The Federal Accounting Standards Advisory Board has been so authorized. The Federal Accounting Standards Advisory Board has been so authorized. The Federal Accounting Standards Advisory Board has been so authorized.

B.32

a. b.

Correct Incorrect

Incorrect

He is "holding out" as a CPA and does work that other CPAs perform. Mere partnership with another CPA is not enough if the other CPA does not "hold out." Working in a corporation with another CPA is not enough if the other CPA does not "hold out." If he does not "hold out" as a CPA, he is not in public accounting, according to the AICPA.

Incorrect

b. c. d.

Incorrect Correct Incorrect

a. b.

Incorrect Incorrect

Incorrect

Correct

B.29

B.33

B.34

This statement is not true. For example, an auditor‘s freedom to talk with clients about employment is not denied. The audit firm simply must take actions to mitigate any possible threat to the quality audit work. Maybe a second-best answer, but the ―efficiencies‖ are offset by the extra review the audit firm is obligated to perform. Former audit partners can retain material retirement accounts only if they are fixed as to amount and timing. (The ―variable‖ word in the question negates the ―fixed‖ requirement.) The public accounting firm must discuss with the audit client‘s board or its audit committee the independence implications of the client‘s hiring the audit engagement team manager as its financial vice president.

CPAs generally prefer to compete on the basis of quality of service rather than price. The conventional wisdom is the opposite of this statement. The FTC dragged the AICPA kicking and screaming into the agreement. The AICPA "principles" statements assert that objectivity is always necessary. Independence is impaired by a direct financial interest in the client. Independence is impaired by the attribution of the financial interest of the spouse. Having a nondependent close relative in an audit sensitive position with the client impairs independence. This is the situation of having an immaterial financial interest in a nonclient investee that is immaterial to the client's financial statements.

B.35

Incorrect

Correct

Incorrect

c. d.

Incorrect Correct

a. b. c.

Correct Incorrect Incorrect

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

B.39

a. b. c. d.

Incorrect Incorrect Incorrect Correct

The AICPA does not grant licenses to practice. The state CPA societies do not grant licenses. The ASB does not grant licenses. The state board is the regulatory agency that grants a license to practice and can revoke one.

B.40

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

Withholding client records is an ―act discreditable.‖ Failing to file or remit tax payments is a felony and as such is an ―act discreditable.‖ Failure to follow standards during an SEC audit is an ―act discreditable.‖ Such advertising violates the Advertising and Other Forms of Solicitation Rule, but not the Acts Discreditable Rule.

Correct

Incorrect

B.36

B.37

B.38

B.41

"Must" is wrong. The public accounting firm can explain why the departure is necessary and then give an unqualified opinion paragraph in the auditors‘ report. The Accounting Principles Rule permits the explanation and the unqualified opinion. "Must" is wrong. The public accounting firm can explain why the departure is necessary and then give an unqualified opinion paragraph in the auditors‘ report. The opinion paragraph can be unqualified, but with the explanation, the report is not "standard." An audit team member cannot even tell a credit agency about the client's payment record. The actuarial assumptions are not required to be disclosed by GAAP or GAAS in tax engagements. Plans of this nature are not required by GAAP or GAAS. Client permission is not needed for information required by GAAP in audited financial statements. These are generally considered outside the reach of professional conduct rules. Failing to file one's own tax return is discreditable. Filing a fraudulent tax return, even for a client in financial difficulty, is discreditable under AICPA interpretation. Employment discrimination is discreditable. No rule forbids reselling products for profit. Authorship itself is not forbidden. The Fees and Other Types of Remuneration Rule prohibits commission compensation for referring products or services to clients for which the CPA performs attest services. The Fees and Other Types of Remuneration Rule permits CPAs to pay fees to obtain clients. (This answer is "close" to correct—forbidden—because the CPA must disclose the fee payment to the new client.)

A direct financial interest disposed before the auditor-client relationship arises does not impair independence. A short sale creates the commitment to acquire the client's stock and impairs independence. Service in the capacity of management during the period covered by the financial statements impairs independence. Performing accounting services and preparing financial statements when the client cannot take responsibility for them impairs independence.

B.42

Incorrect

The Confidential Client Information Rule is not relevant because the CPA did not tell anyone else about the omission. The Integrity and Objectivity Rule -- The CPA knowingly misrepresented facts. The Independence Rule: Independence is not required in tax practice. The Accounting Principles Rule is not relevant because the CPA is not giving an opinion on financial statements' conformity with GAAP.

b. c. d.

Correct Incorrect Incorrect

B.43

a. b. c. d.

Correct Incorrect Incorrect Incorrect

This is a commission—a percentage paid in connection with a business activity. This is an example of a commission, not a contingent fee. This is an example of a commission, not a referral fee. This is an example of a commission, not a nonaudit fee.

B.44

Correct

Incorrect

c. d.

Incorrect Incorrect

A non-CPA who does not have a majority interest and does not have an ultimate responsibility for the firm‘s services can be a partner. A CPA must have ultimate responsibility for the firm services. A non-CPA cannot be the managing partner. A majority owner and partner in the firm cannot own stock in an audit client. Non-CPA owners of the firm must hold a bachelor‘s degree.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS B.45

SEC Independence Rules In these solutions, the following responses do not try to contemplate all exception conditions cited in the text related to the SEC independence rule exceptions. The solution focuses on the primary conditions. a. b. c. d. e. f. g.

B.46

Yes. A member of the engagement team cannot hold a direct financial interest. Yes. No other partner in the Santa Fe office (covered persons) can own direct financial interest in CCC. Yes. Immediate family members of covered persons in the firm cannot hold direct financial interest in CCC. Yes. The son (presumed a dependent) is also an immediate family member. No. According strictly to the definition, the father is a close family member (not an immediate family member), so the financial interest in CCC does not impair independence. Yes. Controlling interests in audit clients when held by close family members of covered persons in the firm impair independence. Yes. Independence is impaired when close family members of a covered person in the firm (Javier) holds a job with a client in an accounting or financial reporting role.

SEC Independence and Nonaudit Services In these solutions, the following responses do not try to contemplate all exception conditions cited in the text related to the SEC-prohibited nonaudit services. The solution focuses on the primary conditions. a. b.

c. d. e.

f. g. h.

Independence is impaired because the SEC does not allow bookkeeping or other services by the audit team preparing financial statements. Independence is impaired because the SEC does not allow involvement of ―covered persons‘‖ in financial information systems design and implementation work to include designing or implementing a software system or supervising the client‘s system. Independence is impaired because the audit firm audited its own work. Independence is not impaired. Auditors can audit actuarial calculations when they were originally prepared by clients‘ actuaries (just like auditing a client-prepared depreciation schedule). Independence is not impaired. According to the literal rule, the outsourced internal audit work does not cover financial controls and financial statements, and Section has in place its own internal audit director with complete authority for all aspects of the work. Independence is impaired. Churyk is a covered person (having authority in the chain of command) and performs a management function by signing stock option documents on behalf of Section. Independence is impaired because the SEC rule is clear to prohibit all aspects of human resource activity for audit clients. This item is written to induce thought without keying directly to SEC-prohibitions on broker– dealer services. However, a conservative conclusion is that independence is impaired because the audit firm (albeit indirectly) performed broker–dealer services for the audit client. Independence appears not to be impaired. While these export-import tax services are close to legal services, they do not involve strict legal work that requires admission to a lawyer‘s bar association (admission to practice before a U.S. court) and are therefore probably OK.

B.47

Independence, Integrity, and Objectivity Cases The author team would like to gratefully acknowledge Jeanie Folk‘s additional explanations in parts b and g which clarify the given interpretations. a.

The Independence Rule. Honorary Directorships and Trusteeships. While independence is ordinarily impaired if a CPA serves on an organization‘s board of directors, members can be honorary directors of organizations such as charity hospitals, fund drives, symphony orchestra societies, and similar not-for-profit organizations so long as: (1) (2) (3) (4)

B.48

The position is in fact purely honorary. Listings of directors show she is an honorary director. She restricts participation strictly to the use of her name. She does not vote or participate in management functions.

Form of Organization and Name Rule. This is not a violation, but students should note that Wolfe is holding himself out to be a CPA and performing the types of services normally performed by CPA firms. However, Wolfe can call himself a CPA (that is, include that designation after his name on his business card). He uses the terminology "and Associates" in the name of his firm but does not indicate that it is a CPA firm. As such, there is no violation of the Code of Conduct.

The Independence Rule. This rule prohibits a covered member from acting in the capacity of a manager, employee, promoter, or trustee of a client. Generally, independence is impaired if the public accounting firm even appears to outside observers to be working in the capacity of management or employee of the client. So, this is likely that this would be a situation that would impair independence.

The Independence Rule. Independence is not impaired. Poirot's loan is "grandfathered" because it was acquired before 1992 and it was obtained from a financial institution for which independence was not required (Farraway was not a client before merger with Nearby) but later became part of an audit client's portfolio.

The Independence Rule. Independence is impaired. Not even home loans made under normal lending conditions are exempt from the prohibition. Paying off the old grandfathered loan does not matter.

The Independence Rule. Independence is impaired. Because the accounting firm and its partners own more than 50 percent of the partnership, the loan is considered to be a prohibited loan from a client.

The Independence Rule. Independence is not impaired. The CPAs own less than 50 percent of the partnership. Note that it is generally important to distinguish between direct and indirect financial interests. As stated in an interpretation to the code of conduct, "the financial interests held by a limited partnership are considered to be indirect financial interests of a covered member who is a limited partner as long as the covered member does not control the partnership or supervise or participate in the partnership‘s investment decisions." As such, because this is an indirect investment, if the investment of the CPA's was material to their net worth, they could not audit the partnership. However (and perhaps this is the tricky part), this case does not indicate that the CPAs do (or intend to) audit the partnership (as is the case with item h).

The Independence Rule. Independence is impaired. Because Schultz can order the investment under the insurance contract, the financial interest is a prohibited ―direct‖ financial interest.

Independence, Integrity and Objectivity Cases The following is relevant for responses a, b, c, d, e, and f. 1-421 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The Independence Rule.: In general, when the present management of a client commences or expresses an intention to commence legal actions against its public accounting firm, the public accounting firm and the client management may be placed in adversary positions in which the management's willingness to make complete disclosures and the auditors‘ objectivity may be affected by self-interest. Independence may be impaired whenever the auditors and the client or its management are in positions of material adverse interest by reason of actual or threatened litigation. Various situations are sometimes difficult to generalize, and the following responses are guidelines expressed in AICPA Ethics Interpretations (Effect of Litigation). a.

Independence would be impaired: An expressed intention by the client to begin litigation alleging deficiencies in audit work is considered to impair independence if the public accounting firm concluded that there is a strong possibility that such a claim will actually be filed.

Independence would be impaired: The commencement of litigation alleging deficiencies in audit work impairs independence.

Independence would be impaired: The commencement of litigation by the public accounting firm alleging management fraud or deceit would definitely impair independence.

Independence could be impaired: The claim under subrogation by the insurance company would not necessarily affect auditors‘ independence on its client. In this case, the client and members of management are not the plaintiffs. However, this situation would have to be carefully evaluated by the CPA firm. If members of Contrary management are going to testify on behalf of the insurance company's interest and thus act in an adversary relation to the public accounting firm, independence would likely be impaired.

Independence would not be impaired: Litigation not related to the audit work, whether threatened or actual, for an amount that is not material to the audit form or to the financial statements of the client would not usually be considered to affect the CPA-client relationship in such a way as to impair independence.

Independence would not necessarily be impaired: The class action lawsuit against both public accounting firm and company in itself would not alter fundamental relationships between the management and directors and the public accounting firm and therefore would not be considered to have an adverse impact on the auditors‘ independence. These situations should be examined carefully, however, because the potential for adverse interests may exist if cross-claims alleging that the covered member is responsible for any deficiencies or if the covered member alleges fraud or deceit by the present management as a defense are filed against the covered member.

Independence is impaired. The CPA's financial interest in Dove Corp. (as an investor) is sufficiently large to allow Lisa to potentially influence the actions of Dove. Because Dove has a significant ownership interest in Tate Company, the CPA's independence would be considered impaired for the audit of Tate Company. Simply stated, the CPA's ability to influence Dove Corp. could permit Lisa to exercise a degree of control over Tate Company that would place the CPA in a capacity equivalent to that of a member of management.

Independence is impaired. Queens‘s financial interest in Hydra is sufficiently large enough (12 percent) for it to exert influence. Because Queens‘s audit client, Howard, owns 46 percent of Hydra, Queens can clearly exert influence over Hydra. Because Howard‘s financial position will be dependent in part on the financial performance of Hydra, Queens cannot possibly be independent in its audit of Howard because of its ownership in Hydra.

The Independence Rule:

B.49

(1)

Assuming that the First National Bank is a profit-seeking enterprise, the independence of the auditors is not impaired by the association of the two individuals who served both as members of the auditing firm and as directors for the client during the period examined as long as they have ended all ties with the bank and are not involved in the audit.

(2)

The auditors‘ services may consist of advice and technical services, but the former controller must not make management decisions or take positions that might impair objectivity. The independence of the auditing firm would be compromised by any partner making a decision on loan approvals and the minimum balance checking account policy but normally not by the former controller‘s performing a computer feasibility study. If the former controller's participation in the feasibility study was objective and advisory, and if the former controller‘s advice was subject to effective client review and decision, the firm's independence has not been compromised. It is desirable, however, that the former controller could not participate in the audit of the First National Bank's financial statements.

The Independence Rule: The acceptance by the CPA of the unsecured interest-bearing notes in payment of unpaid fees would not be construed as discrediting the CPA's independence in relation to Cather because the notes are merely a substitution for an open account payable. The rule of professional conduct that prohibits a CPA from having any financial interest in a client does not extend to the liability for the CPA's fee. Under SEC rules, however, a definite arrangement for paying the notes must be stated by the client. However, the acceptance of two shares of common stock (or prior commitment to accept stock) would be a violation of the Independence Rule. Any direct financial interest such as common stock holdings are construed as discrediting the CPA's independence.

The Independence Rule: The Code of Ethics does not apply to Debra. She's neither a CPA nor a member of AICPA. However, the ruling does apply to independence of a firm if an employee accepts more than a token gift. Independence is impaired because an AICPA member cannot permit employees to break rules that she or he is obligated to observe.

The Independence Rule: Independence is considered impaired. At the time a member issues a report on financial statements, the client should not be indebted for more than one year's fees. In the Groaner case, the debt would be for last year and the current year audit fees. Groaner will have to pay the fees for last year when the current year report is ready (or else get a non-independent disclaimer). The past due fees take on characteristics of a loan within the meaning of the Independence Rule, and collection may depend on the nature of the auditors‘ report on the financial statements.

The Integrity and Objectivity Rule: The CPA has violated the rule. The CPA (1) lacked integrity, (2) knowingly misrepresented facts by omitting the gain in the current-year tax return, and (3) subordinated CPA judgment to another (the client). The proper action is to file an amended return for last year and request a refund and then file a correct return for this year.

The Integrity and Objectivity Rule: Both CPAs probably violated Rule 102. Lestrade has a conflict of interest in owning another business that provides services to her employer and (apparently) not disclosing the business to Baker's board of directors. The "prepaid expenses" classification is wrong. Lestrade has falsified an entry in the accounts and in the financial statements (a violation of the Acts Discreditable Rule). Both CPAs have fooled the external auditors by lying about the related-party loan and the repayment terms.

Integrity and Objectivity This is a true case. It is clear that Deloitte subordinated its judgment to the judgment of the other firms. This is clearly against the Integrity and Objectivity Rule. Students‘ opinions will typically vary as to the need for other auditors‘ opinions. However, it should be emphasized that while CPAs may be persuaded by 1-423 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

others that, based on the facts of the case, a change in the CPAs‘ position is warranted, the CPAs should not change their judgment solely because someone else makes a different judgment based on the facts. The transaction in question was one of the focal points during an investigation of Liven, and regulatory bodies and experts in accounting and auditing took exception with regard to recording any of this as revenue.

B.50

B.51

General and Technical Rule Cases a.

The General Standards Rule: The competence provision the rule is probably not violated. A CPA can learn about a technical area while work is in progress, in particular, when considering that Cheese acquired significant technical expertise (competence) by placing Gilliam on the audit team.

The Compliance with Standards Rule: The CPA violated the fundamental principle of reporting because the CPA prepared financial statements and (apparently) did not render a report of the work and the degree of responsibility as required by GAAS. This topic is also covered in Chapter 2. The CPA should have attached a compilation report to the unaudited financial statements, declaring lack of independence. The CPA is "associated with" the financial statements, practices public accounting, and should render a report.

The Accounting Principles Rule: There is no violation. The rule refers to official pronouncements made by bodies designated by Council (i.e., FASB), not to GAAP in general. GAAP is "all the accounting that has authoritative support." SEC requirements hold the place of highest level of authoritative support for public companies, but Monty is not a public company. The SEC-required tax reconciliation disclosure is not in FASB pronouncements. Thus, it is not required to report in accordance with GAAP.

The Accounting Principles Rule: No violation exists. Chapman is following the exception clause of the Accounting Principles Rule, believing that a departure from FASB pronouncements is necessary to prevent financial statements from being misleading, explaining the departure, then giving the unqualified opinion. This topic is also covered in Chapter 12.

Responsibilities to Clients’ Cases a.

The Confidential Client Information Rule: Retaining an outside mail service to handle confirmation of accounts receivable for the CPA is not an acceptable practice. The confirmation of receivables is an important part of the audit, and therefore cannot be delegated to a nonaccountant, unsupervised by the CPA. Such an arrangement would violate the fundamental principle of performance. In addition, the use of an outside mailing service for this work would be a violation of The Confidential Client Information Rule concerning the confidentiality of information obtained from the client's records. The public accounting firm would be making available to outsiders (the mailing service's personnel) a list of the client's customers and their outstanding balances.

The Confidential Client Information Rule: The CPA has violated the rule. The CPA should seek client permission to disclose information to anyone (including a successor auditor). The banker should ask Candentoe to permit a conversation with the CPA, and refusal should itself raise questions and cautions for the banker.

The Confidential Client Information Rule: A prospective purchaser may review the client files before purchasing the practice, but client permission must be obtained to turn them over to a new

owner. Turning over work papers and business correspondence to a purchaser of a public accounting practice would be proper only if the clients to whom such papers relate has have given consent. Otherwise, the action would be a violation of Rule 301 regarding the confidentiality of information obtained from clients.

B.52

The Confidential Client Information Rule: Importantly, this rule is not intended to help an unscrupulous client cover up illegal acts or otherwise hide information by changing CPAs. The former CPA should at a minimum suggest that Henry (successor) ask Harvard Co. to permit Jacoby, the former CPA, to discuss all matters freely. If Harvard refuses, Henry can consider himself warned. Upon withdrawing, the fired CPA, Jacoby, should have stated all her reasons and her knowledge of frauds in a letter to Harvard Co. Then in answer to Henry's inquiry, she could suggest that he ask Harvard to show him the letter. (Author's note: Notwithstanding the rule of confidentiality, the fired CPA would do Henry a great disservice if she did not make sufficient effort to put him on guard.)

The Confidential Client Information Rule: Wallace violated the rule. Information gained in the course of work for a client (B. Ward, individual tax client) is confidential and cannot be disclosed to any other client or any other person without B. Ward‘s express permission.

The Fees and Other Types of Remuneration Rule: Fiddle violated this rule, which prohibits contingent fees on uncontested tax matters for both original and amended returns.

The Fees and Other Types of Remuneration Rule: Fiddle violated the rule by charging a contingent fee. Because the rules imply that auditors are not independent if they have received a contingent fee "during the period covered by the financial statements," the CPA cannot be Faddle's independent auditor.

The Fees and Other Types of Remuneration Rule: Philby violated this rule by taking a contingent fee from a client for which attest (audit) services were performed. Burgess, Maclean, and Cairncross are all considered Philby‘s clients. Philby performed the audit of Maclean for Cairncross (the holding company) at the direction and request of Burgess. The fee as described— paid only if the IPO is successful—is a contingent fee.

Other Responsibilities and Practices Cases a.

The lien under state law does not matter for the Acts Discreditable Rule. Stout violates this rule if he does not return the cash disbursement journal.

The CPA committed a discreditable act according to the Acts Discreditable Rule. The CPA Examination is "nondisclosed," and inducing exam takers to recite the questions for disclosure purposes in violation of their agreement not to disclose is clearly a discreditable act.

According to the Advertising and Other Forms of Solicitation Rule, it does not appear that this rule was violated. Information about the CPA‘s firm, educational background, and professional affiliations is permitted under. Testimonials are permitted, but the comparisons with other CPAs are inadvisable because they are probably not based on verifiable facts.

According to the Advertising and Other Forms of Solicitation Rule, it does not appear that the rules of conduct were violated. The AICPA rules of conduct do not prohibit dual practice, and the dual letterhead description is permitted. The CPA should also determine whether the state bar permits such practice and letterhead description.

There is no violation of The Fees and Other Types of Remuneration Rule. Referral fees are permitted as long as they are disclosed between parties, which they are in this situation.

This is likely a violation of Form of Organization and Name Rule because others could assume that a partnership existed among the CPAs. For example, any reports issued under the joint heading would violate this rule. The letterhead should not be used showing the names of two accountants when a partnership, in fact, does not exist.

There is no violation of Form of Organization and Name Rule. The rule permits retention of the retired partner's name in the name of the successor partnership.

B.53 AICPA Independence and Other Services. This is the suggested answer based on the information in the problem: Impair Independence? No

Code Section ET 1.295.120.02.d ET 1.295.120.03.b ET 1.295.120.02.g

Post client-approved entries to a client‘s trail balance

Authorize client‘s customer credit applications

Yes

Use CPA‘s information-processing facilities to prepare client‘s payroll

Use CPA‘s information-processing facilities to generate checks for client treasurer‘s signature Advise client management about the application or financial effect of provisions in a employee benefit plan contract.

Have emergency signature authority to cosign cash disbursement checks in connection with client‘s hospital benefit plan.

Yes

ET 1.295.115.04.c

As an investment advisory service, provide analyses of client‘s investments in comparison to benchmarks produced by unrelated third parties

ET 1.295.155.02.b

Take temporary custody of client‘s investment assets each time a purchase is made as a device to reduce cash float expense

Yes

ET 1.295.155.03.c

ET 1.295.120.02.f ET 1.295.115.03.b

B.54

General Ethics. This question asks students to reflect about the "whatever-you-can-get away-with" issue. The answers will vary in a dramatic way, so this tends to be a great question for class discussion. Of course, an act has the same ethical character whether it is known to others or not. And students must remember that an act that affects no one but the agent (rare as such acts may be) is one that has no substantive ethical implications. The latter part of the question asks the student to project himself or herself into his or her future business role.

B.55

Competition and Audit Proposals. The audit proposal scenario was adapted from the Wall Street Journal article "Ethics on the Job: Companies Alert Employees to Potential Dilemmas" (July 14, 1986). It was reported to have been used in a company ethics training/awareness session. Typically, for such case types, it is unlikely to generate a solution that everyone will agree with. Thus, it is a good problem to be used to generate class discussion. Having said that, the Wall Street Journal reported the following solution points that came up in the session: Some participants said that Dena should do as she's told. She's not on a level where she's supposed to think. She doesn't know all the facts. It may not be what she thinks. However, others said that Dena should refuse to take the proposal because the situation has a "bad smell." She should keep her own hands clean of the situation.

B.56

Engagement Timekeeping Records. As in all cases of this type, a "solution" is difficult. Some discussion thoughts: 1-426 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

a. b.

d. e.

Ed is indeed lying by making false timekeeping records. The budget appears to be unrealistic. Apparently, Sara did not know (or did not care) that seven cash accounts had been added and therefore the work should take longer (probably in comparison to last year's time budget). It is important to remember that Sara might be able to increase the audit fee because of the additional work. So, it is absolutely essential that Ed tell Sara why the work took longer than anticipated. There is a very good reason for the extra time. Ed does not seem to give credit to Sara for the possibility of explaining why the work took longer. The case seems to set Sara up as a tyrant about the budget. Ed compounds the lie by putting the extra time in a budget area where someone else will seem to have fewer hours to do another segment of the work (internal control evaluation). Ed is also improving his chances of getting caught because surely Sara can see that his work had little or nothing to do with internal control evaluation. Juggling the time records, if successful, will have an effect on next year's audit staff. Auditors typically use the prior-year actual time records to help plan the current time budget. If they are misstated, the next time budget may also be unrealistic. Sooner or later, some poor assistant will have to suffer the consequences!

B.57

Audit Overtime. Many aspects of this case are similar to the situation outline in Problem B.56. So, many of the same issues outlined in its solution also apply in this situation. a. Of course, one big difference is that Elizabeth did not allocate the extra time to a different budget category. Rather, she just donated four hours of her own time (maybe seven hours if she was not paid for the time worked at home). As you can see, her action makes it look like the work can be done in six hours next year, which is probably not the case. b. Receiving help from her husband overnight should not raise any new issues except perhaps that a violation of The Confidential Client Information Rule has occurred because Elizabeth has revealed client information to someone outside the firm. Beyond this rule violation, this event just increases the number of unreported hours. c. Leaving the work with her husband also raises the new issue of having the audit work completed in an unsupervised manner by someone that is not employed by the firm and who may or may not be qualified to do it correctly. In fact, students should ask whether Elizabeth reviewed all her husband's work before putting it in the working paper file.

B.58

Conflict of Clients' Interests. This situation raises a typical "Who's the client?" question. Unfortunately, the relevant relationships are William's individual engagements with Jack and Bill because Williams would have essentially the same problem if Oneway Corporation were not a client. The situation is "unfortunate" because Williams is in a no-win situation. If he keeps Bill informed, he might save the Oneway engagement and Bill's friendship, but he will suffer the guilt of having engaged in industrial espionage and might face an ethics complaint for having ignored the rule of accountants' confidentiality. If Jon keeps quiet, he might lose the engagement and a significant portion of his personal income at least temporarily. If Williams believes rules are the most important element of ethical behavior and the consequences of action or inaction must fall where they may, he will refuse Bill's request with an eloquent and sympathetic explanation of the professional reasons for not discussing other clients' business affairs. A happy outcome for this approach depends upon Bill's understanding the difficult situation he has created for Williams. If Williams believes in weighing the "good and evil consequences" of ethics-related choices, he will need to decide which ultimate outcome is most desirable: Bill's well-being (and his own income) or Jack's and Jill's well-being, whatever it may be.

B.59 a.

AICPA Code of Conduct London violated a number of Code of Conduct Rules, including the Independence, Integrity and Objectivity, Confidential Client Information and Acts Discreditable Rules.

London could receive any of the penalties available to the PCAOB and the state board including admonishment, suspension, or expulsion.

c. A discussion of the penalties should ensue. B.60

Disciplinary Action

Richard Huff was censured for a failure ―to exercise due professional care, including appropriate professional skepticism, and failed to obtain sufficient appropriate audit evidence‖ on an audit of a financial institution when working as a partner for Grant Thornton. As a result of Huff‘s ―failure to perform the audit in conformity with PCAOB standards, Huff lacked an appropriate basis to authorize the issuance of Grant Thornton's unqualified opinion‖ on the financial statements of his client. Huff was censured by the PCAOB in 2019. He was suspended from practicing for one year and ordered to complete additional training in the financial services industry (PCAOB Release No. 105-2019-001, February 26, 2019, available at www.pcaobus.org). B.61

Ethics Case

Sally violated the Acts Discreditable Rule. According to this rule, a member who fails to comply with applicable federal, state, or local laws or regulations regarding the timely filing of his or her personal tax returns or tax returns of the member‘s firm, or the timely remittance of all payroll and other taxes collected on behalf of others may be considered to have committed an act discreditable to the profession.

Sally could receive any of the penalties available to the AICPA and the state board including admonishment, suspension, or expulsion.

c. A discussion of the penalties should ensue. Opinions may range from the least punitive penalty because Sally has now resolved her legal difficulties to the most severe penalties because the publicity regarding a member of the profession portrays a negative image of the profession and will send a message to the public regarding professional conduct of other members. That is, some students will want to make an example of Sally‘s behavior.

B.62

Mini-Case: Ethics

NOTE TO INSTRUCTOR: For this assignment, question 6 from the Andersen Mini-Case is applicable. 6.

B.63

Opinions will vary. David Duncan directed the actual shredding of documents and probably knew an investigation was imminent. Even if he had received direction from Nancy Temple concerning the document retention policy, he had the opportunity to determine the applicability of the policy to the situation and the ramifications of following the policy in this instance. Remember that many people have gone to jail or suffered even greater consequences utilizing the defense that they were only following orders – or, in this case, policy.

Mini-Case: Nonaudit Services and Independence NOTE TO INSTRUCTOR: For this assignment, questions 1 through 3 from the KPMG Mini-Case are applicable. 1.

The position of the American Institute of Certified Public Accounting (AICPA) on performing tax services for clients is consistent with the general prohibition against performing ―management‖ duties for the client. In this particular scenario, the public accounting firm could provide tax planning advice and prepare the client‘s tax returns; however, the public accounting firm should not be making operating decisions (including tax planning decisions) that affect the client.

The AICPA also provides guidelines for tax services for CPAs in public practice (for both audit and nonaudit clients). Those guidelines can be found in the Statements on Standards for Tax Services and, among others, requires that (see TS 100): 

A CPA should not recommend that a tax return position be taken with respect to any item unless the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged.



A CPA should not prepare or sign a return that the member is aware takes a position that does not meet the Statements on Standards for Tax Services.



A CPA may recommend a tax return position that the CPA concludes is not frivolous as long as the CPA advises the taxpayer to appropriately disclose.



When recommending tax return positions and preparing or signing a return on which a tax return position is taken, a member should, when relevant, advise the taxpayer regarding potential penalty consequences of such tax return position and of the opportunity, if any, to avoid such penalties through disclosure.

However, the standards do recognize that, when recommending a tax return position, a member has both the right and responsibility to be an advocate for the taxpayer with respect to any position satisfying the Statements on Standards for Tax Services. This ―advocacy‖ position has caused many to believe that it is difficult for a CPA to provide tax services to audit clients because the advocacy might ―spill over‖ into the audit work. As a direct result of the KPMG case, the Public Company Accounting Oversight Board (PCAOB) recently adopted rules related to tax-shelter advice provided to an accounting firm‘s audit clients. These rules, which are currently being reviewed by the Securities and Exchange Commission for final approval, prohibit the following types of services related to tax shelters: 

Tax services involving contingent fees for tax services.



Tax services related to marketing, planning, or opining in favor of the tax treatment of a confidential transaction or if the services are related to transactions that are based on aggressive interpretations of tax laws and regulations.



Tax services to members of management (or their families) who serve in financial reporting roles at an audit client.

An exception to the prohibition would exist if the firm ―reasonably‖ believes the strategies have a greater than 50 percent chance of being upheld if challenged by the Internal Revenue Service (see ―Accounting Firms Get New Curbs on Tax Shelters,‖ Wall Street Journal, July 27, 2005, p. C1, C4.). 2.

Sarbanes-Oxley has placed some restrictions on the extent and type of nonaudit services that can be provided by a company‘s audit firm. For example, under Sarbanes-Oxley, an audit firm can no longer provide information, consulting, or internal auditing services to its attestation clients. As a result, companies desiring such services are contracting them with other providers (in many cases, large audit firms). The Wabtec Corp. and Intel Corp. examples discussed in this case illustrate how the nonaudit services provided by large accounting firms may actually limit companies‘ choices of auditors.

The most frequently cited example of permitting nonaudit services to be provided by audit firms to their attestation clients is the ―knowledge spillover‖ effects; that is, information learned by the audit firm as they are providing these services will enable them to better identify areas of risk and

conduct a more effective and efficient audit. The primary disadvantage cited for permitting nonaudit services to be provided by audit firms is related to independence. Simply stated, as the audit firm is providing a higher level of services to its attestation clients, the financial dependence on those clients increases, making auditors less likely to challenge client management on important issues arising during the attestation engagement. B.64

Mini-Case: Nonaudit Services and Independence NOTE TO INSTRUCTOR: For this assignment, questions 1 and 2 from the GE Mini-Case are applicable. 1.

The requirements of Sarbanes-Oxley appear to enhance perceptions of auditors‘ independence because they prohibit certain types of nonaudit services that have been controversial in terms of their impact on auditors‘ independence (financial information systems design and implementation and internal audit outsourcing). In addition, while Sarbanes-Oxley allows other types of nonaudit services, the entity‘s audit committee must explicitly approve the services. This latter requirement would seem to provide users more assurance that the audit committee carefully considered potential conflicts of interest prior to approving nonaudit services.

In 2000, General Electric (GE) paid fees to KPMG for nonaudit services of $64.2 million ($50.4 for financial information systems design and implementation and $13.8 million for tax services). This is substantially higher than the fees paid for audit and audit-related services ($39.4 million). One potential downside of auditors insisting on adjustments to GE‘s financial statements is the fear of losing future revenues from nonaudit services should GE decide to engage another firm to provide those services. In 2004, 2006, 2008 and 2010, the fees paid to KPMG for nonaudit services were substantially less than that in 2000 (e.g., $8.9 million in 2004 versus $64.2 million in 2000). Furthermore, the fees paid for audit services were substantially higher in the years after 2000 (e.g., total audit and audit-related fees of $125.8 million in 2008 versus $39.4 million in 2000). As a result, GE‘s auditors do not have the same monetary incentives related to nonaudit service revenues in the years after 2000 that they had previously.

B.65

Mini-Case: Effect of Sarbanes-Oxley on Fees NOTE TO INSTRUCTOR: For this assignment, questions 3 and 4 from this Mini-Case are applicable. 3.

An initial review reveals that total fees paid to KPMG increased following the issuance of Sarbanes-Oxley but not as significantly as might have been expected. For example, the total fees paid to KPMG in 2004 ($102.6 million) actually decreased from fees paid in 2000 ($103.6 million). However, it is important to note that the fees paid in 2008 ($133.0 million) were markedly higher than those paid in any of the other years. However, the fees paid in 2010 ($108.9 million) were lower than those paid in 2008. Sarbanes-Oxley appeared to have the following effect on GE‘s fees: 



The prohibition of providing financial information systems design and implementation services eliminated this fee after 2000; as noted previously, this fee was a significant portion of the total paid by GE to its auditors in 2000.



The fees paid for tax services also decreased in 2004, 2006, 2008, and 2010 compared to the level of these fees in 2000 and 2002. While tax services were not prohibited by

Sarbanes-Oxley, it is possible that the requirement that audit committees specifically approve all nonaudit services may have reduced the extent of tax services provided to GE by KPMG.

The total fees paid by Fortune 100/500 entities to their auditors were quite stable over this period of time; for both groups of companies, the highest total fees were paid in 2000. In addition, both groups of companies experienced slight increases in their total fees paid to auditors from 2002 through 2010. The effects of Sarbanes-Oxley on fees paid to auditors by Fortune 100/500 companies are similar to the effects on GE, namely: 

 

The internal control requirements of Sarbanes-Oxley significantly increased the percentage of total fees that were classified as audit fees in 2004, 2006, 2008, and 2010. In addition, the SEC‘s revised definition of audit fees may have resulted in some of this increase. The prohibition of providing financial information systems design and implementation services eliminated this fee after 2000. The fees paid for tax services were lower in 2004, 2006, 2008, and 2010 as compared to the levels of those fees in 2002. While tax services were not prohibited by SarbanesOxley, it is possible that the requirement that audit committees specifically approve all nonaudit services may have reduced the extent of tax services provided to Fortune 100/500 companies similar to GE.

MODULE C Legal Liability LEARNING OBJECTIVES Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1. Identify and describe auditors‘ exposure to lawsuits and loss judgments.

1, 2

2. Specify the characteristics of auditors‘ liability under common law and cite some specific case precedents.

3, 4, 5, 6, 7, 8, 9

29, 32, 35, 36, 37, 40, 46, 49, 55, 56

61, 62, 63, 64, 65, 66, 67, 68, 69, 70, 71, 72, 76(*), 82

3. Describe auditors‘ liability to third parties under statutory law.

4. Specify the civil and criminal liability provisions of the Securities

11, 12, 13, 14, 15, 16, 17

38, 42, 44, 47(*), 48, 53, 57, 59, 60

73(*), 74(*), 76(*), 77(*), 78

Act of 1933.

5. Specify the civil and criminal liability provisions of the Securities Exchange Act of 1934.

18, 19, 20, 21, 22, 23, 24

41, 43, 45, 47(*), 50, 51, 52, 58

73(*), 74(*), 77(*), 79, 80, 81

6. Understand recent developments that affect auditors‘ liability to clients and third parties.

25, 26, 27, 28

30, 33, 34, 54

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS C.1

Auditors owe clients the responsibility to perform services in accordance with the contract (engagement letter) and to conduct the audit in accordance with generally accepted auditing standards. Auditors owe third parties the responsibility of conducting the audit in accordance with generally accepted auditing standards. In each of these situations, auditors can be held liable if their failure to perform in accordance with the contract or generally accepted auditing standards results in an economic loss to clients or third parties.

C.2

Common law liability uses legal precedent to identify the responsibility of parties in situations where there is no violation of a written law or statute. Clients and nonshareholder third parties can bring suit against auditors for common law liability. Statutory law liability involves the violation of a written law. Third-party shareholders can bring suit against auditors for statutory liability.

C.3

Under common law liability, clients can bring suit against auditors for either breach of contract or tort actions. Prior to bringing suit, clients must demonstrate: 1. 2. 3. 4.

They suffered an economic loss. Auditors did not perform in accordance with the terms of the contact (for breach of contract). Auditors failed to exercise the appropriate level of professional care (for torts). The breach of contract or failure to exercise the appropriate level of professional care caused the loss.

C.4

Auditors owe clients the responsibility for conducting the audit using the appropriate level of professional care. If they do not do so, they have tort liability for ordinary negligence, gross negligence, or fraud.

C.5

To bring suits against auditors under common law, third parties must demonstrate: 1. 2. 3. 4.

C.6

They suffered an economic loss. Auditors failed to exercise the appropriate level of professional care. The financial statements contained a material misstatement. The loss was caused by reliance on the materially misstated financial statements.

The Ultramares Corp. v. Touche case concludes that if auditors conduct their work with such gross negligence as to amount to constructive fraud or constructive deceit, they may be liable for damages. The decision, and also a part of the ―rule‖ from Ultramares, was that auditors are not liable to unidentified third parties for ordinary negligence. One can infer that liability for ordinary negligence might be imposed when third-party beneficiaries are known (but this was not explicit in the court opinion). The Ultramares rule is being eroded today. No longer is privity the shield that it was in 1931, and auditors are being held responsible for a greater degree of care. However, in some states, the Ultramares view is still in effect.

C.7

Privity refers a situation in which parties have a contractual relationship. Auditors owe contracting parties (e.g. clients) a duty to perform the audit with the appropriate level of professional care. Liability can be imposed for situations in which auditors exhibit ordinary negligence. A primary beneficiary is the party an audit or accounting service is intended to benefit. The distinguishing feature of a primary beneficiary is that this party is either named in the contract or auditors know of this party by name. Auditors are generally liable to primary beneficiaries for ordinary negligence. Foreseen parties are groups or individuals that client intends the information to benefit and that could reasonably be expected to rely on auditors‘ work. In certain jurisdictions, auditors can be liable to foreseen parties for ordinary negligence when the plaintiff justifiably relied on the information and suffered a loss on such reliance. Foreseeable parties are the creditors, investors, or potential investors whose decisions normally rely on audited financial statements and opinions on those financial statements. In some jurisdictions, auditors can be liable to foreseeable parties for ordinary negligence.

C.8

Auditors‘ defenses against clients under common law include: 1.

Auditors exercised the appropriate level of professional care (torts) or performed the engagement in accordance with the terms of the contract (breach of contract).

The client‘s economic loss was caused by a factor other auditors‘ failure to demonstrate an appropriate level of professional care or breach of contract (causation defense).

Actions on the part of the client were, in part, responsible for the loss (contributory negligence).

Auditors‘ defenses against third parties under common law include: 1.

The third party did not have appropriate standing (privity) to sue in the jurisdiction.

The third-party‘s loss was caused by events other than the financial statements and auditors‘ examination.

Auditors‘ work was performed in accordance with professional standards (GAAS), which is generally interpreted to mean that auditors did not commit ordinary negligence.

C.9

In lawsuits related to compilation and review, accountants can use the proper disclaimers, which were presented in the non-audit service report, as an additional defense to insulate them from lawsuits from third parties.

C.10

Liability under statutory law arises when purchasers or sellers of securities suffer an economic loss and the financial statements contain a material misstatement.

C.11

Transactions governed by the Securities Act are the initial issuance of securities by registrants to the investing public through a market (primarily through in initial public offering).

C.12

A registration statement is a set of documents filed with the SEC prior to the offering of securities. Registration statements introduce liability to auditors because the prospectus (which is contained within the registration statement) includes audited financial statements and disclosures. As a result, if purchasers of securities suffer an economic loss and the financial statements contain a material misstatement, auditors may be liable for the losses suffered by purchasers.

C.13

Section 11 of the Securities Act of 1933 effectively shifts the burden of proof regarding the appropriate level of professional care during the examination to auditors, whereas this proof is the plaintiff‘s duty under common law. Furthermore, the plaintiff does not have to be in a privity relationship or known third-party beneficiary relationship with auditors. Also, the plaintiff does not have to prove reliance on the materially misstated financial statements or that the loss resulted from the materially misstated financial statements.

C.14

In a civil suit under section 11 of the Securities Act of 1933, the plaintiff only has to prove that a loss was suffered and that the financial statements contained a material misstatement. To avoid liability, the defendant auditors can either prove that (1) the engagement was conducted according to GAAS (―due diligence‖ defense) or (2) the loss was caused by factors other than the misstated financial statements and auditors‘ examination (―causation‖ defense).

C.15

The due diligence defense asserts that auditors conducted a reasonable investigation, which ordinarily means that the audit was conducted in accordance with GAAS. The causation defense asserts that all or part of the plaintiffs‘ losses were caused by factors other than financial statements and auditors‘ examination.

C.16

Section 17 of the Securities Act of 1933 is the antifraud provision relating to the offer or sale of securities. Section 24 of the Securities Act of 1933 defines criminal penalties and relates to willful violation of duties with respect to a statutory registration or requirement to register a sale of securities.

C.17

In Escott v. BarChris Construction Corp., the court concluded that auditors did not conduct an appropriate review of subsequent events and, in fact, did not perform steps included in the audit program.

C.18

Form 10-K includes annual financial statements that are audited by independent auditors. Form 10-Q includes quarterly financial statements that are reviewed by independent auditors. Form 8-K provides a summary of an entity‘s major events; auditors may review or assist in the preparation of these reports.

C.19

Regulation S-X contains requirements for audited annual and unaudited interim financial statements filed with the SEC. Regulation S-K contains requirements relating to all other business, analytical and supplementary financial disclosures in SEC filings. Financial Reporting Releases are SEC staff reports that express new rules and policies about accounting and disclosures required or encouraged by the SEC. Staff Accounting Bulletins contain unofficial but important interpretations of Regulation S-X and Regulation S-K by SEC staff.

C.20

Under the Securities Exchange Act of 1934, purchasers or sellers of securities can bring suit by proving: 1. 2. 3. 4.

C.21

They suffered an economic loss. The financial statements contained a material misstatement. The loss was caused by reliance on the materially misstated financial statements. Auditors were aware that the financial statements contained a material misstatement.

Auditors‘ defenses under the Securities Exchange Act of 1934 are that they acted in good faith and had no knowledge of the material misstatements.

C.22

Under section 32 of the Securities Exchange Act of 1934, criminal penalties include fines of up to $5 million and imprisonment for up to 20 years (these levels represent increases provided by Sarbanes-Oxley). In addition, violations of the provisions of Securities Exchange Act of 1934 by entities other than natural persons (such as accounting firms) are punishable by fines up to $25 million.

C.23

Scienter is a mental state embracing the intent to deceive, manipulate, or defraud (for example, if auditors have knowledge of misstatements in the financial statements and intentionally fail to disclose these misstatements in their reports). Ernst & Ernst v. Hochfelder and Denise L. Nappier et al. v. PricewaterhouseCoopers both concluded that parties could not recover damages against auditors because they were unable to demonstrate scienter on the part of the defendants.

C.24

C.25

C.26

The major differences between auditors‘ liability under the Securities Act of 1933 and Securities and Exchange Act of 1934 are: 1.

The Securities Act of 1933 applies to original purchasers of securities under a registered offering while the Securities and Exchange Act of 1934 applies to purchasers and sellers of securities under ongoing exchanges after the initial offering. Auditors are liable for ordinary negligence, gross negligence, or fraud under the Securities Act of 1933; they are only liable for gross negligence or fraud under the Securities Exchange Act of 1934.

Auditors have the burden of proof under the Securities Act of 1933; plaintiffs (purchasers or sellers of securities) have the burden of proof under the Securities Exchange Act of 1934.

Under the Securities Act of 1933, auditors‘ defenses are that a GAAS audit was conducted or the loss was caused by factors other than the financial statements and auditors‘ examination; under the Securities and Exchange Act of 1934, auditors‘ defenses are that the audit was conducted in good faith and auditors were not aware of the materially misstated financial statements.

Some of the major changes in auditors‘ liability under Sarbanes-Oxley include: 1.

Extended the statute of limitations for bringing a suit under the Securities and Exchange Act.

Increased monetary fines and imprisonment penalties for violations of the Securities and Exchange Act.

Increased imprisonment penalties for mail fraud and wire fraud.

Monetary fines and imprisonment penalties for the alteration and destruction of documents.

Increased period over which records must be retained by accounting firms.

Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of a damage award from the any defendant(s), regardless of the defendant‘s relative degree of fault. Proportionate liability only permits recover from defendant(s) based on their relative degree of fault.

C.27

The Private Securities Litigation Reform Act provided the following terms for proportionate liability: 1.

The total responsibility for loss is divided among all parties responsible for the loss.

However, if other defendants are insolvent, a solvent defendant‘s liability is extended to 50 percent more than the proportion found at trial.

Only the defendants who knowingly committed a violation of securities laws remain jointly and severally liable for all the plaintiffs‘ damages.

The Class Action Fairness Act expanded federal jurisdiction over class action lawsuits and moves many class action cases from state courts to federal courts. C.28

To reverse the perceived concerns with the Private Securities Litigation Reform Act (attorneys filing securities class action lawsuits in state courts that follow joint and several liability doctrines), Congress enacted the Securities Litigation Uniform Standards Act. This act‘s most significant provision requires that class action lawsuits with 50 or more parties must be filed in the Federal courts.

SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS C.29

C.30

C.31

a. b. c.

Incorrect Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Constructive fraud represents reckless behavior, not a lack of reasonable care. Fraud represents intention to deceive. Gross negligence is similar to constructive fraud and represents lack of minimal care. Ordinary negligence represents lack of reasonable care and is often proven by demonstrating that auditors failed to follow GAAS in conducting the audit. Joint and several liability can impose the entire amount of loss in a case against auditors, which is less favorable than proportionate liability. The reasonably foreseeable user approach provides auditors with the greatest exposure to liability to third parties for ordinary negligence. The foreseen third party approach is more favorable to auditors than the reasonably foreseeable approach, but auditors may still be exposed to the entire amount of the loss. Proportionate liability is most favorable to auditors because they will only be liable for damages to the extent they were found to be at fault. The difference between the perception of the users of the statements and auditors‘ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users‘ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors‘ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users‘ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors‘ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users‘ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors‘ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users‘ belief that a GAAS audit will uncover all instances of fraud.

C.32

C.33

C.34

C.35

C.36

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

a. b.

Incorrect Correct

Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

Breach of contract depends solely on the performance of auditors and the client per the contract (engagement letter). A tort is a lawsuit filed by the plaintiff who believes that they have suffered damage due to another party‘s failure to exercise the appropriate level of professional care. Securities litigation is a term that defines criminal and civil actions regarding unfair or criminal practices in the purchase or sale of securities. Constructive fraud is a term used to define repetitive actions that show a pattern of recklessness or disregard for the truth or other party‘s well being. While constructive fraud may be the cause of the losses, the wording in the question does not suggest that such a fraud occurred. This is the total amount of the loss, and auditors were not determined to be 100% at fault. Auditors‘ liability cannot be zero because they were found to be partially at fault. Auditors pay 45%, which is the 30% at fault plus another 15% (or 50% of the level at fault) because they are the only solvent defendant. Since auditors are the only solvent defendant, liability is not limited to the 30% at fault. Auditors pay 45%, which is the 30% at fault plus another 15% (or 50% of the level at fault) because they are the only solvent defendant. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. Under proportionate liability, auditors would be liable for some extent of the damages, even if they did not knowingly commit the violations. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages. The accountant and client have a privity relationship for the consulting services. The accountant‘s best defense would be to prove that the client did not carry out its part of the recommendations from the consulting work. Plaintiffs can always measure some damages, and suit would not be brought if the client did not have good reason to measure damages. While the accountant can argue that the work was done properly, the accountant‘s best defense would be to prove that the client did not carry out its part of the recommendations from the consulting work. The Credit Alliance view holds auditors responsible to primary beneficiaries for ordinary negligence, who are identified and known to name by auditors. This is the broadest view of privity, as defined by Rosenblum, Inc. v. Adler. This is the restatement of torts view of privity. The Credit Alliance view holds auditors responsible to primary beneficiaries for ordinary negligence, who are identified and known to name by auditors, therefore this answer is not correct.

C.37

Correct

Incorrect

Correct

Incorrect

C.39

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections.

C.40

Incorrect

c. d.

Incorrect Correct

Foreseeable third parties are parties whose decisions normally rely on audited financial statements and opinions on those financial statements; however, they are not known to auditors by name. Foreseen third parties are parties that might reasonably be expected to use auditors‘ work; however, they are not known to auditors by name. There is no designation known as ―general third party‖. Primary beneficiaries are known by name to auditors and, in some cases, are specifically identified in the contract (engagement letter).

Incorrect

Correct

Incorrect

C.38

C.41

The engagement letter obtained at the beginning of the engagement is the most effective method of expressing the nature of limits on compilation and review engagements. Compilation and review engagements do not result in the preparation of auditors‘ opinions. The engagement letter obtained at the beginning of the engagement is the most effective method of expressing the nature of limits on compilation and review engagements. Reporting the nature of the work at the conclusion of the engagement is not as effective as doing so in the engagement letter at the beginning of the engagement. Management letters are delivered at the conclusion of the engagement, so reporting the nature of the work at the conclusion of the engagement is not as effective as doing so at the beginning of the engagement. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity‘s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity‘s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity‘s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity‘s financial statements.

Privity is not a necessary condition to bring suit under the Securities Exchange Act of 1934. Prior to bringing suit, the investor would need to demonstrate that a loss was suffered. These are appropriate defenses under the Securities Exchange Act of 1934 and demonstrate lack of scienter. Entities are required to file financial statements with the Securities and Exchange Commission for their shares to be traded on national exchanges.

C.42

C.43

C.44

C.45

C.46

NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the response labeled “correct” is not true and those labeled “incorrect” are true. a. b.

Incorrect Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

c. d.

Incorrect Incorrect

Incorrect

Correct

Incorrect

The Securities Act of 1933 relates to the initial issuance of securities. Auditors‘ liability typically arises because of their involvement with audited financial statements. Third parties are only required to demonstrate that the financial statements are materially misstated; they are not required to demonstrate reliance on these financial statements. Auditors are liable for ordinary negligence under the Securities Act of 1933. Information related to auditor changes is not required to be disclosed in the 10-K annual report. Information related to auditor changes is one of the ―special events‖ entities must report on Form 8-K. Information related to auditor changes is not required to be disclosed in the S-1 registration statement. Information related to auditor changes is one of the ―special events‖ entities must report on Form 8-K. Information related to auditor changes is not required to be disclosed in the 10-Q quarterly reports. Information related to auditor changes is one of the ―special events‖ entities must report on Form 8-K. Information related to auditor changes is one of the ―special events‖ entities must report on Form 8-K. Section 11(b) requirements appear to be satisfied, since the chairman produced the information about the planned use of the proceeds, made a reasonable investigation, and the information is not made on the authority of another ―expert.‖ Section 11(b) requirements appear to be satisfied, since the consulting engineer is an expert and made a reasonable investigation connected with his or her own work. Section 11(b) requirements appear to be satisfied, since the president relied on the work of the consulting engineer expert and had no reason to believe the engineer‘s report was erroneous. In this case, while the officers relied on auditors‘ work, they were aware of materially misstated financial statements and, therefore, liable under Section 11(b). Under both common law and section 10(b), plaintiffs must prove they suffered losses. Unlike common law, section 10(b) does not have a privity requirement (―any purchaser or seller‖ can sue the accountants). Under both common law and section 10(b) plaintiffs must prove reliance. Under both common law and section 10(b) plaintiffs must prove their reliance caused their losses. Credit Alliance v. Arthur Andersen established auditors‘ liability to primary beneficiaries for ordinary negligence. Fleet National Bank v. Gloucester Co. established auditors‘ liability to foreseen third parties for ordinary negligence. Rosenblum, Inc. v. Adler established auditors‘ liability to foreseeable third parties for ordinary negligence, which provides broader exposure for auditors than the groups in choices (a) and (b). Ultramares did not establish any exposure for auditors to liability to third parties for ordinary negligence, just gross negligence or fraud.

C.47

C.48

C.49

C.50

C.51

C.52

Incorrect

Correct

Incorrect

b. c.

Incorrect Correct

Incorrect

Correct

Incorrect

b. c. d.

Incorrect Incorrect Correct

Correct

Incorrect

a. b. c. d.

Correct Incorrect Incorrect Incorrect

Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. The SEC does not guarantee or represent that the information in the registration statement is true. Registration is not insurance against loss from the investment. Financial information that has been examined by independent auditors is either included in the registration statement or incorporated by reference. Inside information about the entity‘s trade secrets is not provided in the registration statement. (If it were, it would no longer be inside information!) This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. While the plaintiff has the responsibility to prove AOW failed to exercise the appropriate level of professional care, conducting the audit in accordance with generally accepted auditing standards would be an effective defense. Regulation D governs the nonpublic issuance of securities to limited groups of investors. Form 8-K is the periodic special events report. Form SB-1 is one registration forms of the Securities Act of 1933. Regulation S-X is the compendium of accounting rules that governs the form and content of Forms 10-K and 10-Q. The Ernst & Ernst v. Hochfelder case related to the failure of plaintiffs to prove scienter. The Escott v. BarChris Construction Corp. case demonstrated ordinary negligence on the part of auditors in a review of subsequent events. Smith v. London Assurance Corp. was related to ordinary negligence on the part of auditors in failing to identify an embezzlement scheme occurring at a client. The Ultramares case was related to auditors‘ liability for ordinary negligence (and not scienter) to third parties. Form 10-K is the annual report. Form 10-Q is the quarterly report. Form 8-K is the periodic special events report. Regulation S-X provides guidelines for the content of financial information submitted to the SEC.

C.53

C.54

C.55

C.56

C.57

Incorrect

Correct

Incorrect

Scienter must be demonstrated under the Securities Exchange Act of 1934; under the Securities Act of 1933, auditors are responsible for ordinary negligence. Plaintiffs must establish that the financial statements contained a material misstatement. Proving reliance on the materially misstated financial statements is not necessary. Proving that reliance on the materially misstated financial statements caused the loss is not necessary.

NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the response labeled “correct” is not true and those labeled “incorrect” are true. a.

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

Correct

Incorrect

Sarbanes-Oxley does not include new definitions or situations that constitute securities fraud. The amendments in the Act provide greater penalties for auditors, but do not increase auditors‘ responsibilities for identifying fraud. Sarbanes-Oxley requires that the CEO and CFO certify the financial statements. Sarbanes-Oxley specifies penalties for destruction of records in federal investigations for both accounting firms and auditors. Sarbanes-Oxley increases penalties for mail fraud and criminal violations of the Securities Exchange Act of 1934. Because the suit is being brought by a third party and not a client, lack of privity is not a viable defense; third parties do not need to demonstrate a privity relationship to bring a suit alleging fraud against auditors. If auditors can demonstrate that third parties did not rely on the financial statements, the loss was not caused by the financial statements or auditors‘ examination, providing a basis for the causation defense. Disclaimers in engagement letters cannot protect auditors from lawsuits against third parties for misstated financial statements. Contributory negligence would be an available defense against suits brought by clients, but not third parties. Because Hall engaged Locke and Locke did not perform in accordance with the terms of the engagement letter, Hall can bring suit for breach of contract. Locke‘s negligence would also permit a suit to be brought on that basis. Hall could bring suit for negligence as well as breach of contract. Hall could bring suit for breach of contract as well as negligence. Hall could bring suit for either breach of contract or negligence. For initial offerings, investors only need to demonstrate that a loss was suffered and that the financial statements contained a material misstatement. For initial offerings, investors do not need to demonstrate that they relied upon the financial statements in making their investment decisions. For initial offerings, no negligence or culpability on the part of the auditor needs to be demonstrated to bring suit. For initial offerings, no negligence or culpability on the part of the auditor needs to be demonstrated to bring suit.

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Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

Under the Securities Exchange Act of 1934, a viable defense for Donalds would be that they were not aware that the financial statements contained a material misstatement, since under this Act plaintiffs must demonstrate scienter on the part of the auditor. Section 10(b) would apply to Donalds, since these securities were publiclytraded and information was filed with the SEC. It is not necessary to demonstrate privity to bring suit under the Securities Exchange Act of 1934. Auditors cannot avoid liability under the Securities Exchange Act of 1934 through any disclaimer language in their engagement letters. Under the Securities Act of 1933, Hex does not need to demonstrate any level of auditor culpability, including knowledge that the financial statements contained a material misstatement. No level of auditor culpability (including negligence) needs to be demonstrated. Under the Securities Act of 1933, Hex does not need to demonstrate that he relied on the financial statements in making his investment decision. Hex needs to demonstrate that he suffered an economic loss and that the financial statements contained a material misstatement.

NOTE TO INSTRUCTOR: Since this question asks which of the defenses would be least helpful, the response labeled “correct” would be least helpful and those labeled “incorrect” would be helpful. a.

Correct

Incorrect

Investors do not need to demonstrate privity to bring suit under the Securities Act of 1933. A viable defense for West would be that the audit was conducted in accordance with GAAS (known as the due diligence defense). A viable defense for West would be that the loss was caused by factors other than the financial statements and auditors‘ examination. If Hex was aware of the material misstatements, these misstatements could not have been the cause of Hex‘s losses.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS C.61

C.62

Breach of Contract a.

Auditors can be in breach of contract for:  Failing to meet established deadlines  Failing to provide the services described in the contract  Charging fees differently then agreed in the contract

Clients can be in breach of contract for:  Failing to provide documents as agreed in the contract  Failing to pay audit fees in a manner described in the contract  Failing to make available key personnel as agreed in the contract  Failing to disclose information known by management (e.g. known frauds) as agreed in the contract

The best defenses are:  There is no breach of contract (i.e., auditors met all the contract provisions)  The breach of contract was due to the client‘s failure to perform as specified under the contract  Fulfillment of the contract became impossible because of circumstances beyond auditors‘ control (for example, auditors cannot be liable for breaching a provision of a contract to count inventory held in a warehouse if the inventory was destroyed)

Liability to Clients a.

Clients may bring suit against auditors for either breach of contract or tort actions.

To bring suit against auditors, clients must ordinarily demonstrate: 1. 2. 3. 4.

They suffered an economic loss. Auditors did not perform in accordance with the terms of the contract (for breach of contract). Auditors failed to exercise the appropriate level of professional care (for tort actions). The breach of contract or failure to exercise the appropriate level of professional care caused the loss.

Auditors‘ defenses against legal actions brought by their clients include: 1. 2. 3.

Auditors exercised the appropriate level of professional care (tort) or performed the engagement in accordance with terms of the contract (breach of contract). The client‘s economic loss was caused by a factor other than auditors‘ failure to exercise appropriate levels of professional care or breach of contract. Actions on the part of the client were, in part, responsible for the loss.

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Liability to Clients (continued) d.

The potential basis for legal action in each of these cases is as follows:   

Brown Company: Because the delay in completing the audit resulted in additional costs of financing, Brown‘s legal action would be based on Thomas‘ inability to complete the audit on a timely basis. Green Stores: Green Stores‘ legal action would be based on Thomas‘ failure to identify the embezzlement scheme during its audits of Green Stores‘ financial statements. Green Stores would likely seek recovery of the $2 million in losses. Fuchsia, Inc: Fuchsia‘s legal action would be based on any additional costs associated with changing auditors and any costs associated with delays in providing audited financial statements to its lenders as a result of the need to change auditors.

NOTE TO INSTRUCTOR: Depending upon the assumptions made by students, they may arrive at different conclusions with respect to Thomas’ liability to its clients in some of these scenarios. The key is that they considered the relevant facts and potential defenses that may either increase or decrease the likelihood of an unfavorable outcome to Thomas. Brown Company: It appears that Brown Company‘s most viable action for recovery will be alleging that it informed Thomas of the need to have the audit completed by a certain date and that failure to do so would constitute a breach of contract. There is no evidence that a substandard audit has been conducted or that Thomas did not exercise the appropriate level of professional care. In this case, the following are important considerations: 1. Was a deadline or other date explicitly communicated by Brown Company to Thomas or otherwise identified in the engagement letter? If no such date was communicated, or any deadline known by Thomas, it would not appear that Brown Company has a viable suit for breach of contract. 2. Regardless of the response to (1) above, did Brown Company‘s actions result in delays or otherwise affect Thomas‘ ability to complete the engagement on a timely basis? If so, this might serve as a defense for Thomas in the form of contributory negligence on the part of Brown Company. Green Stores: Green Stores would most likely bring suit for tort liability, alleging that an audit conducted under generally accepted auditing standards would have revealed the existence of the embezzlement scheme and prevented the $2 million loss. In this case, the following are important considerations: 1. Were Thomas‘ audits conducted in accordance with generally accepted auditing standards? If so, Thomas would likely use the defense that it exercised appropriate levels of care during the engagement and emphasize that a GAAS audit cannot be relied upon to detect all instances of fraud. 2. Regardless of the response to (1) above, could Green Stores have taken actions (through strengthening internal controls or other) to create an environment that would have made the creation and execution of this embezzlement scheme more difficult? Certainly, if Thomas had communicated internal control deficiencies to Green Stores in previous audits related to the treasurer‘s role or controls surrounding this function, it would appear that Thomas could assert contributory negligence as a defense. Fuchsia, Inc.: This may appear to be a frivolous suit, but that would not prevent Fuchsia from alleging that Thomas‘ actions resulted in the losses described in the scenario. While it is difficult to comprehend how Fuchsia‘s decision to change auditors would result in liability to Thomas, Thomas would appear to have a strong defense that its actions were, in fact, done to exercise appropriate levels of professional care by demonstrating how Fuchsia‘s accounting treatment departed from generally accepted accounting principles.

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Common Law Responsibility for Errors and Fraud a.

Given the nature of the auditing procedure, it appears that Whitman had an obligation to follow up on the 13 missing receiving reports; had he done so, he may have identified the fraudulent scheme involving Lock. The fact that Whitman indicated that the problem was resolved in the audit documentation without any evidence that these receiving reports were located and included in the files would likely expose Hoffman & Whitman to liability.

The problem description indicates that this portion of the audit was conducted without the appropriate level of professional care. While sampling transactions is acceptable under generally accepted auditing standards, Whitman‘s follow-up and explanation of the missing receiving reports leaves much to be desired. At the very least he could have reviewed the reports produced by Lock at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition. Auditors had some evidence that fraud might exist, but it appears that they failed to apply extended audit procedures properly.

Common Law Responsibility for Errors and Fraud Donovan‘s responsibility under generally accepted auditing standards is to plan the audit to detect errors and frauds that would have a material effect on the financial statements. Whether McCoy would prevail depends upon two questions: (1) The materiality of the undiscovered embezzlement and whether it was concealed by falsifying the financial statements and (2) Donovan‘s planning and performance of appropriate audit procedures. If the amount is material, Donovan is potentially liable. If Donovan performed a careful audit exercising the appropriate level of professional care, liability probably would not attach. If not, Donovan might be found guilty of ordinary negligence and liable to McCoy with whom he had a privity relationship. All the common law features (damage, reliance, cause, failure to perform with the appropriate level of professional care, and privity) are present. The actual resolution of liability is only a matter of their degree. McCoy, however, can be faulted (although probably not in a contributory negligence sense) for not informing Donovan about the anonymous letter. Donovan should have obtained signed representations in which McCoy asserted he knew of no errors or frauds that he had not told Donovan. With such signed representations, Donovan might not be found liable at all. Even if Donovan is judged liable, McCoy could probably recover only the embezzled amounts after the audit ($65,000) but not the amounts embezzled prior to the audit ($40,000).

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Auditors’ Liability for Fraud a. b.

Auditors will be liable for fraud to all third-party users of financial statements under common law or statutory law. Fraud is a misrepresentation of fact that the individual knows to be false. Constructive fraud (sometimes referred to as gross negligence) is the failure to provide any care in fulfilling a duty owed to others. The primary difference between these two levels of professional care is actual knowledge on the part of auditors, which is present under fraud but not under constructive fraud. Auditors will be liable for constructive fraud to all third-party users under common law and the Securities Act of 1933. To be held liable under the Securities Exchange Act of 1934, scienter (or intent to deceive, manipulate, or defraud) must be shown. While scienter may be present in situations representing constructive fraud, this will not always be the case. Clearly, auditors should be liable in cases where they intend to deceive. While intention is not present under constructive fraud, the level of performance and lack of care is so great that it seems appropriate to hold auditors liable for constructive fraud.

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Accusation of Fraud a.

In this case, a claim for fraud does not appear to exist. To show fraud auditors would have to: 1.

Be aware that the inventory amounts were incorrect and not require adjustment of these amounts or modification of the auditors‘ opinion.

Conclude that the inventory amounts were fairly stated without performing any auditing procedures (reckless disregard for the truth);

Neither of these actions can be shown from the information provided. The failure to adequately review the inventory is more likely classified as ordinary negligence, or possibly gross negligence, rather than fraud. b.

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If auditors were charged with fraud their defenses would include: 1.

They performed the audit of inventory in accordance with generally accepted auditing standards;

Management perpetrated the fraud, which included the objective of defrauding auditors;

There was no intent or pattern of behavior on the part of auditors that indicates that they committed a fraud.

Common Law Liability Exposure a.

Creditors appear to be claiming that auditors knew the financial statements were not presented in accordance with generally accepted accounting principles.

If action is brought based on fraud, the lack of privity would not be an important issue. Auditors are liable to all parties under common law in instances where they commit fraud.

Yes, the firm is liable to the creditors, because the firm was aware of the failure to disclose the cash received as well as the contingent liability.

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Common Law Liability Exposure a.

Under a privity of contract definition, Risk Capital will not prevail. Under the strict privity rule, parties must be signer of a contract to have a standing to sue for ordinary negligence. Therefore, regardless of whether Wilson and Wyatt committed ordinary negligence, Risk Capital has no legal standing to sue Wilson and Wyatt for ordinary negligence.

While debatable, under a strict primary beneficiary standard, Risk Capital will not likely prevail. In the case of Credit Alliance v. Arthur Andersen (1985), the court held that auditors are not liable for ordinary negligence to third parties unless (1) auditors were aware that a particular third party intended to rely on the auditors‘ opinion and the financial statements, (2) the third party was specifically identified to auditors, and (3) some action by auditors showed they acknowledged the third-party‘s identification and intent to rely on the opinion and financial statements. For example, auditors could include the name of the bank and acknowledge its intended use of the financial statements in the engagement letter. While elements (1) and (2) are present, it does not appear that element (3) is present (acknowledgement of the third-party‘s identification). In addition, the standing of Risk Capital would vary depending upon the jurisdiction in which the case is heard. NOTE TO INSTRUCTOR: There is likely to be some debate about element (3). An effective extension of this part of the problem would be to identify what type of action(s) on the part of auditors would satisfy element (3).

Under the foreseen party standard defined by restatement of torts, Risk Capital will prevail. The restatement of torts extends liability for ordinary negligence to ―foreseen‖ third parties not explicitly known to auditors. Under this approach, auditors may be subject to claims for ordinary negligence if they know that the auditors‘ opinion and financial statements will be delivered to unidentified investors and creditors. Specific acknowledgement is not required. Auditors must only be aware that the auditors‘ opinion and financial statements will be used by some third party. In this instance, the contact clearly specified Risk Capital and the use of the financial statements. As a result, Risk Capital would be classified as a foreseen third party (if not a primary beneficiary).

Common Law Liability Exposure a.

Yes, Smith will be liable to the bank. The elements necessary to establish an action for liability for fraud under common law are clearly present. There was a material misstatement in the financial statements, intent and knowledge of the misstatements (scienter), actual reliance by the bank on the materially misstated financial statements, and economic damages resulting from that reliance. If action is based upon fraud, there is no requirement that the bank establish privity of contract with Smith. If the action by the bank is based on ordinary negligence, the bank may still be in position to bring suit, depending upon the extent to which Smith was aware that his work would be used by the bank and the jurisdiction in which this case occurred. Based on the facts presented, it is difficult to determine whether the bank is a primary beneficiary. However, because Smith was aware that the financial statements would be used to obtain a loan, the bank would appear to be at least a foreseen third party and could prevail under the restatement of torts doctrine.

No, Smith will not be liable to the lessor because the lessor was a party to the ―secret‖ written agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if the lessor was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of ―unclean hands‖ (―contributory negligence‖) precludes him from obtaining relief.

Smith was not independent with respect to the audit of Juniper. The lack of independence is raised by Juniper‘s threat to sue Smith in the event the loan was not obtained.

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Common Law Liability to Third Parties a.

Primary beneficiary: A person known by name to the auditors for whose primary benefit the auditor other accounting service is performed.

Foreseen third parties: A limited class of individuals or organizations that could be reasonably expected to rely on auditors‘ work.

Foreseeable third parties: Third parties whose decisions normally rely on audited financial statements and opinions on those financial statements.

Because Flacco knew that Raven‘s financial statements would be presented to Baltimore National Bank to secure financing, Baltimore National Bank would likely be classified as a primary beneficiary.

Because Flacco was aware that the financial statements would be presented for bank financing, Regional State Bank would likely be classified as a foreseen third party. Regional State Bank would not be classified as a primary beneficiary because Flacco was not specifically informed of this party‘s potential use of the audited financial statements.

Maryland Equity Partners would most likely be classified as a foreseeable third party. While a case could be made that a private equity firm is a foreseen party, based on the pre-audit conference, it appears that Raven Company is pursuing bank financing and not equity financing. In any case, because Flacco was not informed of Maryland Equity Partners‘ use of the financial statements, this party would not be classified as a primary beneficiary.

If Flacco committed ordinary negligence (through failing to conduct a GAAS audit), Baltimore National Bank would prevail in any jurisdiction, since auditors are responsible for ordinary negligence to primary beneficiaries. With respect to Regional State Bank and Maryland Equity Partners, Flacco‘s culpability would depend upon the jurisdiction in which the action was brought. If legal action was brought in a state using the Restatement of Torts approach, Regional State Bank would likely prevail against Flacco, but Maryland Equity Partners would not (assuming this latter party would be considered to be a foreseeable third party and not foreseen third party). If legal action was brought in a state using the reasonable foreseeability approach, both Regional State Bank and Maryland Equity Partners would prevail against Flacco. It is likely that Flacco‘s failure to perform meaningful substantive procedures related to Raven‘s accounts receivable would constitute gross negligence. In that case, all three parties would prevail against Flacco, since auditors owe all third parties liability for actions that reach the level of gross negligence.

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Common Law Liability to Third Parties a.

Because these parties provided loans to Madeoff and are non-shareholder third parties, they would pursue litigation against Allen based on common law rather than statutory law.

Because First Trust and Bank was specifically known to Allen by name (in fact, First Trust and Bank was explicitly identified by name in the engagement letter), it would be classified as a primary beneficiary. Allen was aware that the purpose of the audit examination was to enable Madeoff to obtain financing. Because of this knowledge, as well as the fact that Madeoff had previous business relationships with MoonTrust, MoonTrust would likely be classified as a foreseen third party. The classification of Alice Lay is somewhat debatable. On one hand, any third party could potentially provide funding to Madeoff; using this rationale, one might classify Alice Lay as a foreseeable third party. However, because it is not common practice for entities to obtain financing from customers and Alice Lay had never entered into a loan agreement of this nature in the past, a justification could be made that she does not meet the classification as a foreseeable third party.

The failure of Allen‘s audit to comply with generally accepted auditing standards represents ordinary negligence, assuming that Allen‘s audit did not demonstrate a lack of minimum care or Allen did not possess actual knowledge of the material misstatements. For ordinary negligence, the following represents these parties‘ abilities to prevail against Allen: 

As a primary beneficiary who relied upon the audited financial statements and Allen‘s report on the financial statements, First Trust and Bank would likely be able to bring suit and prevail against Allen.



While MoonTrust‘s classification as a foreseen third party suggests that it would be able to prevail against Allen in certain jurisdictions, the fact that MoonTrust did not rely on the audited financial statements and Allen‘s report on the financial statements would make it unlikely that MoonTrust could bring suit against Allen. If MoonTrust did bring suit against Allen and Allen could prove that the loan decision was made prior to receipt of the audited financial statements and auditors‘ report, Allen could attempt to successfully assert the causation defense.



Given Alice Lay‘s very remote and unusual relationship to Madeoff as a provider of capital it is unlikely that Alice would have an appropriate level of standing to bring suit against Allen. However, if Alice could demonstrate that she was a foreseeable third party and could meet the other criteria for bringing suit under common law, she could potentially prevail against Allen.

If Allen was aware of the material misstatements, this would be classified as fraud. Both First Trust and Bank and Alice Lay would be highly likely to prevail against Allen, because auditors are liable to all third party users (regardless of their relationship and classification) for acts of gross negligence or fraud. MoonTrust would still have the burden of demonstrating that they relied on the materially misstated financial statements and Allen‘s report in bringing suit against Allen.

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Liability in a Review Engagement a.

Hotshot in its own right may bring an action, or the other stockholders may bring a derivative action against Mason & Dilworth on behalf of the corporation, for failure to exercise the appropriate level of professional care in failing to detect the fraud. A lawsuit based on constructive fraud might be brought against Mason & Dilworth, because the conduct of the review may be characterized as gross negligence with reckless disregard for the truth. Individual shareholders and lending institutions will claim this is the case, and if upheld, privity of contract will not be a valid defense.

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Third-party financial institutions have rights to sue accountants for failure to exercise the appropriate level of professional care in performing review engagements. As a general rule, third parties, even though not direct parties to a contract, may successfully assert ordinary negligence if they can show that they are members of a class of persons intended to benefit from the services performed by the auditors and that their use of the statements was reasonably foreseeable by the auditors.

Liability Under the Securities Acts a.

To bring suit under the Securities Act of 1933, investors in Orange would need to demonstrate that: 1. 2.

They suffered an economic loss. The financial statements contained a material misstatement.

Under the Securities Act of 1933, LeGrow would be liable to investors for acts of ordinary negligence, gross negligence, or fraud.

To bring suit under the Securities Exchange Act of 1934, investors in Orange would need to demonstrate that: 1. 2. 3. 4.

Under the Securities Exchange Act of 1934, LeGrow would not be liable to investors for ordinary negligence and would clearly be liable for fraud. While some questions surround auditors‘ liability for gross negligence, the findings in the Hochfelder case indicate potential liability for acts of gross negligence. d.

The primary differences in LeGrow‘s liability under the two securities acts are: 

Under the Securities Act of 1933, investors are not required to prove that the loss was caused by the materially misleading financial statements, only that a loss occurred and that the financial statements contained a material misstatement. Thus, the burden of proof under this act is with the auditor. In contrast, under the Securities Exchange Act of 1934, investors have the burden of proving that the loss was caused by the misleading financial statements and that the auditors demonstrated some lack of an appropriate level of performance.



Under the Securities Act of 1933, investors can bring suit for ordinary negligence, gross negligence, and fraud; under the Securities Exchange Act of 1934, investors can bring suit for fraud and, potentially, gross negligence.

Both of the above differences indicate that LeGrow has significantly greater exposure to potential liability under the Securities Act of 1933.

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Liability Under the Securities Acts a.

Jones‘ liability to shareholders of SoftWare would be governed by the Securities Act of 1933, since SoftWare engaged in an initial offering of securities during 2017 and the misstatement related to financial statements filed as part of this offering. Jones‘ liability to shareholders of ExternalDrive would be governed by the Securities Exchange Act of 1934, since the misstatement occurred following the initial issuance of securities.

SoftWare‘s shareholders would only need to demonstrate that (1) they suffered an economic loss and (2) Software‘s financial statements contained a material misstatement. ExternalDrive‘s shareholders would need to demonstrate (1) they suffered an economic loss, (2) ExternalDrive‘s financial statements contained a material misstatement, (3) the shareholders‘ loss was caused by reliance on the materially misstated financial statements, and (4) Jones possessed scienter, or intention to deceive shareholders.

With respect to SoftWare, Jones has two potential defenses: due diligence and causation. Because it appears that a violation of GAAS occurred, Jones will not likely be able to assert the due diligence defense. The fact that overall market conditions have caused similar declines in the stock prices of other software companies might make the causation defense viable for Jones. With respect to ExternalDrive, assuming that shareholders could demonstrate that the loss was caused by the materially misstated financial statements (making a causation defense untenable), Jones could likely assert that he acted in good faith and was not aware of the material misstatement this is consistent with the findings related to the quality of Jones‘ work.

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If Jones possessed scienter, the only potential defense in either case would be to argue that the losses were not related to the materially misstated financial statements. While this would be consistent with the observed decline in market prices of other software companies, Jones‘ knowledge of the misstatements and scienter would make such a defense less effective.

Class Action Lawsuits a. b.

A class action lawsuit occurs when a group of individuals come together as plaintiffs in a common action against a defendant. Individually, plaintiffs involved in a class action may not have been able to hire an attorney because the amount of their claim was small and did not justify the cost. Collectively, however, there may be significant numbers of plaintiffs for an attorney to justify the time commitment for such an action. In addition, when a class includes a large number of plaintiffs from many jurisdictions, the plaintiffs‘ attorney may choose to initiate the action in a jurisdiction that is the most ―friendly‖ to the plaintiffs. All of the advantages to plaintiffs in (b) can be viewed as disadvantages to defendants. In addition, the mere fact that a class action suit makes litigation more likely to occur is a significant disadvantage. The Class Action Fairness Act of 2005 moves many class action lawsuits to federal court where defendants may have a better opportunity to defend themselves. In addition, the Securities

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Litigation Uniform Standards Act requires class action lawsuits with 50 or more parties to be filed in federal courts. The inability for the plaintiffs to select the court (and jurisdiction) in which the case will be heard will likely deter many class action lawsuits. The discussion here will vary depending on the case identified by the student. Instructors should be sure to emphasize the fact that a small number of disgruntled plaintiffs can expose auditors to liability to a large number of individuals.

Liability Under Common Law and the Securities Act of 1933 a.

Union Bank will likely be successful in its ordinary negligence suit against Weaver. To be successful in a lawsuit for ordinary negligence under common law, Union Bank must show that it (1) suffered an economic loss, (2) Weaver failed to exercise the appropriate level of professional care, (3) the financial statements contained material misstatements, and (4) Union Bank‘s loss was caused by reliance on the materially misstated financial statements. Weaver was guilty of ordinary negligence in performing the audit by not confirming accounts receivable, which resulted in failing to discover the overstatement of accounts receivable. Weaver‘s failure to confirm accounts receivable violated generally accepted auditing standards and represented ordinary negligence. Because Union Bank relied on these financial statements in granting the loan, and because Weaver knew that Union Bank would be provided with the financial statements in this decision process, Union Bank assumed the role of a primary beneficiary. Auditors are generally liable to primary beneficiaries for acts of ordinary negligence.

Union Bank will be successful in its fraud suit against Weaver. To be successful in a lawsuit for fraud under common law, Union Bank must demonstrate the same four factors as in part (1). In addition, to demonstrate fraud, Union Bank must prove that Weaver was aware of the material misstatement (in this case, the failure to disclose information about the product liability lawsuit).

Butler‘s stockholders who purchased stock under the preferred stock offering will also be successful in their suit against Weaver under section 17 of the Securities Act of 1933. Weaver‘s failure to qualify the auditors‘ opinion for Butler's potential legal liability was material and done with intent and knowledge, which violates the antifraud provisions in section 17. Weaver will be liable for losses sustained by the purchasers who relied on Weaver‘s opinion.

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Liability Under the Securities Acts a.

After the sale, Fancy will have total assets of greater than $10 million and more than 500 shareholders; as a result, Fancy will be required to register under the Securities Exchange Act of 1934 and file reports on Forms 10-K, 10-Q, and 8-K. Fancy will become a public, ―reporting‖ entity. (Fancy will also be subject to the insider trading, proxy solicitation, and other requirements.) NOTE TO INSTRUCTOR: These dollar amounts and number of shareholders are subject to change.

Any purchaser can sue the entity for failure to file the required registration statement and would be in position to receive a refund of their purchase price. Fancy would also be liable for willful violation of the Securities Act of 1933, which exposes them to monetary fines and imprisonment.

Accredited investors include the following:

     

Financial institutions, such as banks, savings and loans, and insurance companies. Private business development companies. 501(c)(3) charitable organizations. Directors, general partners, or officers of the registrant. Individuals with wealth in excess of $1 million, individual income in excess of $200,000, or joint income in excess of $300,000. Trusts with assets in excess of $5 million.

An offering under Regulation D is exempt from registration requirements under the Securities Act of 1933. Three rules under Regulation D provide exemptions:

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Rule 504:

A sale of ―restricted securities‖ of up to $1 million in a 12-month period.

Rule 505:

A sale of up to $5 million of securities in a 12-month period to an unlimited number of accredited investors (as defined above) and up to 35 additional non-accredited investors.

Rule 506:

Private offerings of ―restricted securities‖ to an unlimited number of accredited investors (as defined above) and up to 35 additional non-accredited investors (unlike Rule 505, these non-accredited investors must have sophisticated knowledge and experience in financial and business matters).

Section 11 of Securities Act of 1933: Liability Exposure Yes, May, Clark & Company would be liable. The situation is covered by the Securities Act of 1933. Some of the key elements are as follows: 

Because the Securities Act of 1933 allows any purchaser to bring suit, privity is not available as a defense to May, Clark & Company.



Chriswell Corporation‘s financial statements contained a material misstatement.



The fact that the market price of the debentures declined following the disclosure of the material misstatements suggests causation. However, it is important to note that demonstrating causation is not necessary to bring suit under the Securities Act of 1933.



While May, Clark & Company made inquiries of the financial vice president and controller regarding material changes in Chriswell‘s financial position since the date of the audit, it made no reasonable effort to verify the results of these inquiries. This would likely be viewed as a violation of generally accepted auditing standards and, therefore, ordinary negligence on the part of Mary, Clark & Company.

Since May, Clark & Company are responsible up to the effective date of the registration statement, they would likely be liable. Chriswell Corporation and its officers would also be liable.

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Rule 10b-5 Liability Under the Securities Exchange Act of 1934 a.

The case should be dismissed. A suit under section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 must establish intent to deceive, manipulate, or defraud (or scienter). Fraud is an intentional tort and as such requires more than failure to exercise the appropriate level of professional care. Although the audit was admittedly performed without the appropriate level of professional care, Gordon & Groton neither participated in the fraudulent scheme nor did they know of its existence. The element of scienter must exist in order to state a cause of action for

fraud under section 10(b) of the Exchange Act 1934, although auditors may have potential exposure for gross negligence even in the absence of scienter. (Refer to the Ernst & Ernst v. Hochfelder decision.) b.

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The plaintiffs might have stated a common law action for ordinary negligence. However, they may not be able to prevail due to the privity requirement. There was no contractual relationship between the defrauded parties and Gordon & Groton. Although the exact status of the privity rule is unclear, it is doubtful that the level of ordinary negligence in this case would extend Gordon & Groton‘s liability to the customers who transacted business with Bank & Company. However, the facts of the case as presented in court would determine this.

Independence and Securities Exchange Act of 1934 a.

One of the important concepts governing auditors‘ independence is that auditors should not be in a position of serving as advocates for their clients. Testifying in court on behalf of the client‘s damage claim is perilously close to serving as an advocate, although many auditors will claim that litigation support services (in general) are appropriate and do not impair independence. While the litigation consulting itself may not impair independence, independence is likely impaired by the unpaid consulting fee of $265,000. AICPA interpretations and rulings hold that past due fees may impair auditors‘ independence in certain situations.

C.81

Violations of generally accepted auditing standards are based on the failure of auditors to exercise the appropriate level of professional care (third general standard). This violation is based on Ward (and, therefore, AOW) not insisting upon disclosure of the appeal of the Civic case, improper deferral of losses on new product start-up costs, and inappropriate accrual of sales revenue.

Ward and AOW appear to have violated section 10(b) by being actively involved in using a ―scheme or artifice to defraud,‖ namely management‘s issuing the materially misstated financial statements with full knowledge of the auditors. Ward, and hence AOW, acted with scienter which is required by section 10(b). In addition, Ward, by willfully enabling the 10-K to be filed with the SEC, seemingly violated section 32 of the Securities Exchange Act of 1934 by knowingly causing materially misstated statements to be filed (the financial statements and the auditors‘ opinion).

Auditors’ Liability Under Securities Exchange Act of 1934 a.

Because Adam is a purchaser of securities of an established registrant, the most likely basis for suit would be under statutory law violations of the Securities Exchange Act of 1934. Adam‘s attorney can bring suit against auditors as follows: 1.

Fraud under the Securities Exchange Act of 1934, section 10b-5. In Ernst & Ernst v. Hochfelder, the court‘s decision indicated that reckless professional work might be a sufficient basis for 10b liability even though scienter is not clearly established. Therefore, if Adam‘s attorney could prove that auditors acted recklessly (i.e., with gross negligence), he might recover loss from auditors.

Criminal liability under the Securities Exchange Act of 1934, section 32. Under United States v. Natelli (1975), Adam‘s attorney must prove that auditors acted willfully and knowingly.

The auditors‘ attorney can use the following defenses to protect auditors from legal liabilities. 1.

With respect to civil liability, auditors‘ primary defenses are that they acted in good faith and had no knowledge of the material misstatements.

With respect to the criminal charges, because the burden of proof was provided by the plaintiff‘s attorney, the auditors‘ attorney should prove that the evidence does not indicate auditors were guilty beyond a reasonable doubt. Most importantly, fraud must be demonstrated to file criminal charges under section 32 of the Securities Exchange Act of 1934.

Section 307 of Sarbanes-Oxley includes a rule that requires an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation to the chief legal counsel or the chief executive officer of the entity. If the counsel or officer does not appropriately respond to the evidence, the attorney is required to report the evidence to the audit committee or board of directors. Either Adam‘s attorney or Joshua Food‘s auditors‘ attorneys should report evidence of the violation to the company‘s management (or audit committee, if management did not take remedial measures).

MODULE D Internal, Governmental, and Fraud Audits LEARNING OBJECTIVES

1. Define internal auditing, describe internal audit

institutions (e.g., the IIA), describe how internal auditors interact with independent auditors, explain internal auditors‘ independence problems, and list features of internal audit reports. 2. Define governmental auditing, describe

governmental audit institutions (e.g., the GAO), describe the three types of governmental audits, discuss the standards and regulations that govern audits, list features of governmental audit reports, and understand the purpose of the Single Audit Act of 1984 and Amendments of 1996. 3. Define fraud examination and the differences in

how external auditors and fraud examiners approach their work. Describe the main objectives of a fraud investigation, how a fraud case is built, and how fraud evidence is handled. Describe the ways CPAs can assist in prosecuting fraud perpetrators.

Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1, 2, 3, 4, 5, 6, 7

21, 22, 23, 24, 27, 28, 31, 32, 36*, 44

45*, 46, 47, 48, 49, 50, 53, 57, 61, 62*

8, 9, 10, 11, 12, 13, 14

25, 26, 29, 30, 33, 34, 35, 36*, 37, 38

45*, 51, 54, 56, 58, 59

15, 16, 17 ,18, 19, 20

39, 40, 41, 42, 43

45*, 52, 55, 60, 62*

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS D.1

Internal audit helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve effectiveness of risk management, control, and governance processes.

D.2

Internal auditors‘ independence is enhanced by having the authority and responsibility to report to a high executive level and to the audit committee of the board of directors. They are most independent, in a practical sense, when they are not under the control or direct influence of operating managers whose functions, operations, and results they may be assigned to audit.

D.3

Internal auditors add value to a company primarily by achieving the following four audit objectives (1) recognizing and analyzing industry, business, and operational risks; (2) improving the economy and efficiency of the operations; (3) ensuring compliance with management directives; and (4) serving as management‘s representative.

D.4

The services provided by internal auditors include performing (a) audits of financial reports and accounting control systems, (b) compliance audits that ensure conformity with company policies, plans, and procedures and with laws and regulations, (c) operational audits that evaluate the economy and efficiency of business process, and (d) audits of effectiveness in achieving program results in comparison to preestablished objectives and goals.

D.5

The Institute of Internal Auditors (IIA) issues International Standards for the Professional Practice of Internal Auditing (IIA Standards). The IIA Standards are classified in three major categories: attribute standards, performance standards, and implementation standards.

D.6

Internal auditors can become certified internal auditors as well as CPAs; other designations are available.

D.7

Management is responsible for enforcing compliance—identifying the laws and regulations, establishing controls to ensure compliance, and monitoring compliance.

D.8

Governmental auditing refers to a variety of services performed in an effort to hold the government accountable and transparent to the public regarding the linking of resources to related program results.

D.9

The Government Accountability Office (GAO) is the accounting, auditing, and investigative agency of the federal government. The GAO audits the departments, agencies, and programs of the federal government (even if they are subject to audits by their own internal audit staffs) to determine whether the laws passed by the U.S. Congress are followed and to determine whether programs are being implemented with economy and efficiency and are achieving desired results.

D.10

The services provided by government auditors include performing (a) financial statement audits that determine whether the financial reports are in conformity with GAAP and governmental regulations, (b) attestation engagements including examining, reviewing, and performing agreed-upon procedures on a subject matter or assertion about a subject matter and reporting on the results, and (c) performance audits, which entail an objective and systematic examination of evidence to provide an independent assessment of the performance and management of a program against objective criteria as well as assessments that provide a prospective focus or synthesize information on best practices or crosscutting issues.

D.11

Governmental and internal auditors must be as objective as possible when developing conclusions about economy, efficiency, and program results. This objectivity is achieved by (1) finding standards for evaluation and (2) using measurements of actual results to (3) compare the actual results to the standards. Finding standards and deciding upon relevant measurements take imagination. 1-458 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

When dealing with standards, measurements, and comparisons, auditors must keep inputs and outputs in perspective. Evidence about inputs—personnel hours and cost, materials quantities and cost, asset investment—is important in connection with reaching economy and efficiency conclusions. For economy, efficiency, and program result conclusions, however, output measurements are equally important. Management has the responsibility for devising information systems to measure output. Such measurements should correspond to program objectives set forth in laws, regulations, administrative policies, legislative reports, or other such sources. Auditors must realize that output measurements usually are not expressed in financial terms. Many economy and efficiency audits and most program results audits are output oriented. Auditors need to be careful not to equate program activity with program success without measuring program results. These features are significantly different from auditors‘ roles with respect to financial statement audits for which the primary concern is with reporting on the accounting for inputs. D.12

GAGAS explicitly requires a review for compliance with applicable laws and regulations. Because most governmental programs are created by regulated grants and operate under laws and regulations, compliance review is very important.

D.13

Auditors‘ reports on financial statements are standardized with wording that all auditors should use all the time. They are ―one-size-fits-all‖ report forms. Internal, governmental, and consulting reports on economy and efficiency and program results, however, need to be adapted to the specific problem and the circumstances. They need to stand on their own for readability, clarity, and content. They use good writing style to convey the essence of the problem, the investigation, the results, and the recommendations. Managers have a chance to respond to criticism and praise, balancing the presentation so that the higher levels of management (board of directors) can be fully informed. Internal and governmental audit recommendations are intended to be followed up for progress reports on implementation of recommendations. As part of the feedback loop for management, internal and governmental auditors can keep alive (―open‖) their good suggestions to see whether managers follow them, especially when managers have agreed to do so.

D.14

The federal government requires audits of state and local governments that receive federal financial assistance through appropriations, grants, contracts, cooperative agreements, loans, loan guarantees, property, interest subsidies, and insurance. When a state or local government, university, or community organization receives federal financial assistance from several federal agencies, the Single Audit Act of 1984, as amended in 1996, (the Act) allows for that organization to obtain a single audit on which all of the agencies can rely.

D.15

Independent auditors of financial statements and fraud examiner approach their work differently. Some of the most important differences are: 

Financial auditors follow a program/procedural approach designed to accomplish a fairly standard job; fraud examiners work in unique and unusual situations in which little is standard.



Financial auditors note errors and omissions; while fraud examiners also focus on exceptions, they must be aware of peculiarities and patterns of conduct as well.



Financial auditors assess control risk in general and specific terms to design audit procedures; fraud examiners habitually ―think like a crook‖ to imagine ways in which controls could be subverted for fraudulent purposes.



Financial auditors use a concept of materiality (dollar size big enough to matter). Most fraud examiners believe that ―immaterial fraud‖ is an oxymoron. Fraud is often larger than it appears, if left unchecked tends to grow, and indicates a lack of integrity on the part of the person or persons involved. For these reasons, fraud examiners often pursue even small frauds.



D.16

Financial audits are based on theories of financial accounting and auditing logic; fraud examination is based on a theory of behavioral motive, opportunity, and rationalizations.

Internal auditors‘ responsibilities go beyond the financial statements. Often control weaknesses and process deviations that are not directly related to the financial statements may indicate fraudulent activity. In addition, in-house internal auditors are extremely knowledgeable in the nuances of their company‘s processes, which enables them to spot unusual activities and deviations from process that other individuals might not recognize. The responsibilities of internal auditors often require the investigation of suspected fraud. Internal auditors are required to use information obtained during the planning and performance of the audit to identify risk that may result in a material misstatement due to fraud. In addition, internal auditors need to be aware of the various types of frauds, their signs, and the need to follow up to determine whether a suspicion is justified; if so, they alert management to the need to call in the experts. A focused effort by internal auditors on the prevention, deterrence, and detection of financial statement misstatements arising from asset misappropriation is consistent with their broad mission of maximizing owners‘ wealth. In carrying out their mission, internal auditors should be aware of the risks and warning signs of fraud.

D.17

In fraud examiners‘ terminology, predication is a reason to believe fraud may have occurred.

D.18

Fraud examiners have attitudes about control systems and materiality that differ from other auditors because fraud examiners have different responsibilities. When a fraud examiner is called, fraud is already known or strongly suspected. Therefore, fraud examiners‘ interest in internal control policies and procedures emanates not so much from evaluating its strengths but from evaluating its weaknesses. Fraud examiners ―think like crooks‖ to imagine fraud schemes that get around an organization‘s internal controls. To a fraud examiner, fraud is compared to an iceberg in the sense that most of it is hidden and only a small part may be visible. Therefore, concerning materiality, fraud examiners think in terms of a cumulative amount.

D.19

Prosecution of fraudsters is advisable because, if left unpunished, they often steal again. In addition, failure to prosecute sends a message to other potential fraudsters in the organization that if caught, they would not be prosecuted.

D.20 Fraud examiners handle information in a different manner than auditors because external, internal, and governmental auditors have standards for care, attention, planning, detection, and reporting of some kinds of errors, frauds, and illegal acts. In addition, fraud examiners have little in the way of standard programs or materiality guidelines to limit their attention to fraud possibilities. However, auditors must always exercise technical and personal care because accusations of fraud should be taken very seriously. For this reason, after preliminary findings indicate fraud possibilities, auditors should enlist the cooperation of management and assist fraud examination professionals when bringing an investigation to a conclusion.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS D.21

D.22

Correct

b. c.

Incorrect Incorrect

Incorrect

a, b, c. Incorrect

D.23

a, b, d. Incorrect

D.24

D.25

D.26

Correct

a, b, d. Incorrect c.

Correct

Incorrect

Correct

According to the Professional Standards for the Practice of Internal Audit, auditor independence is determined by the organizational status of the department and the objectivity of the department and individuals practicing internal audit. There is no specific requirement for the auditors to report to the audit committee There is no specific requirement regarding the organizational status of the audit committee While an audit charter is required, the nature of the audit charter and the audit staff‘s objectivity are not requirements related to the independence of the internal audit department. Although each of these could be a problem for internal audit, the audit department could function with either a reduced schedule or a reduced budget. The chief audit executive would need to provide management with implications of budget and schedule reductions. The fact that the controller would have no training as an internal auditor would mean that the chief audit executive would need to spend time explaining internal audit issues. The most serious problem in having internal audit report to the controller is that the controller would be able to influence the scope of audits over accounting areas that also report to the controller. In addition, the controller could edit reports from internal audit to amend or exclude items related to the performance of the controller or other departments that report to the controller. In adding value to purchasing, the internal audit department is looking for situations that may add unnecessary costs or create a situation in which risks are incurred that may indicate that purchasing is not getting the best price. Having bids that are not independent in nature, delaying the purchase of product (stock outs may result), and questioning the effectiveness and efficiency of new vendor approval policy may all indicate risks that could affect the bottom line. The failure to provide a performance review for new employees is a compliance issue. This could result in inefficiencies (if that person was not performing in the job appropriately), but such inefficiencies would likely be known with or without a review. The five elements of an audit finding include condition, criteria, cause, effect, and recommendation. While having audit findings that are relevant to the audit is clearly a desirable trait, it is not one of the five elements of an audit finding as defined by the Institute of Internal Auditors. Reporting to the managers where they are employed probably imposes independence-impairing pressure on the auditors. Reporting to the agency directors is probably a little better but it still puts the auditors under some managerial pressure. Reporting to (private) political action committees in which they hold membership hints bias to the auditorsreport. Reporting to Congress (which commissions most GAO reports) is the best answer here because it suggests a higher line of communication outside the audited entity itself. Auditing for compliance with laws and regulations is required.

Incorrect

D.27

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Operational auditing has broad objectives. Performance auditing has broad objectives. Management auditing has broad objectives. Operational, management, and performance auditing are considered synonyms. Their objectives go beyond those for auditing financial statements.

D.28

a. b.

Incorrect Incorrect

Correct

Incorrect

Reviewing financial information is a financial audit not an operational audit. Reviewing the feasibility of obtaining the objectives of an organization is a consulting engagement. An operational auditing is an engagement to determine the efficiency and effectiveness of an organization in meeting its goals and objective. Recommendations would be directed at helping to achieve those objectives. Reviewing the company‘s success in meeting profit maximization would likely be a consulting engagement (no recommendation would result) or a performance audit.

Correct

b. c. d.

Incorrect Incorrect Incorrect

D.30

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Auditors cannot usurp the function of the courts. Evaluation of personal skills is probably too subjective. Public opinion standards are not objective enough for audit evaluation. This is ―program results‖ auditing, which is tied to goals set for the agency.

D.31

Correct

Internal auditing typically is broader in scope and objectives than external audit, which is limited to financial statements.

b, c, d

Incorrect

D.32

a, b, d c.

Incorrect Correct

These are normally included in the charter for the internal audit department. The organizational structure of the internal audit department is normally not included in the charter.

D.33

a. b. c.

Incorrect Incorrect Correct

Incorrect

GAGAS is the proper set of standards. A report on compliance is required. Commentary by auditee managers is recommended for performance audit reports but not for reports on financial statements An internal control report is required.

D.29

Understanding internal control is important, but auditing for actual compliance with laws and regulations is more important. Documentation is important, but auditors have to do the basic work before they prepare audit documentation to record it. Exit interviews with managers are important, but because they come toward the end of the audit, results of the compliance (and other) auditing are already known.

A managerial job in the organization being auditing impairs independence in a manner similar to the impairment when an external auditor has a managerial position with an audit client. Election and reporting to the legislature protects independence. Auditing outside the normal assignment normally protects independence. Appointment by the governor and reporting to the legislature protects independence.

D.34

D.35

D.36

D.37

D.38

D.39

D.40

D.41

a. b. c.

Incorrect Incorrect Correct

Incorrect

a, b, d

Incorrect

Correct

b, c, d

Incorrect

a, b, d

Incorrect

Correct

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Correct

Incorrect

Correct

a. b. c.

Correct Incorrect Incorrect

Incorrect

Correct

An opinion on financial statements is required. An internal control report is required. Performance auditing regarding achievement of program goals is not required by the Single Audit Act. (The Act requires the other reports.) A compliance report is required. By definition, expanded-scope governmental auditing includes financial statement audits, attestation engagements, and performance audits. Compliance audits are not considered part of expanded-scope governmental auditing. Determining applicable accounting principles is important for financial statement audits but not for performance audits. Each of these responses are elements of the audit method of defining the problem, gathering the evidence, and evaluating the evidence. The most important considerations are to (d) determine standards, (a) measure the output, and (b) compare output to standards. The review of management controls is a means of analysis rather than a way to achieve objectivity. Auditors can report on internal control without compliance tests. Reports on compliance observance of laws and regulations requires compliance tests. Compliance tests are not required for opinions on financial statements. Compliance tests are not necessary for the simple listing of federal assistance programs and amounts. Fraud examiners ―think like crooks‖ to imagine fraud schemes that get around an organization‘s internal control. External auditors evaluate control strengths as a basis for planning other audit procedures, but fraud examiners do not. External auditors need to determine the materiality threshold to find whether significant misstatement exists in the financial statements. Fraud examiners think materiality in terms of a cumulative amount. Never taking physical inventory indicates a red flag in the control system. It is good that unauthorized parties have no access to the petty cash. In an environment in which a code of ethics is well established and communicated, auditors do not have to pay special attention to employee activities for no reason. If the board of directors has knowledge of all investment transactions, the control risk concerning investment is very low; therefore, auditors‘ special notice and follow up are not needed. Reinforcement of control on checks and supervision is a broad way of fraud prevention. There may be fraud that does not deal with checks. Naming an ―ethics officer‖ may deter those who plan to commit fraud because they can see management‘s attitude to and effort in fraud prevention. However, an ethics officer is a part of a larger overall plan to improve corporate culture such that fraud is less likely Placing ―hotlines‖ around the workplace could expose the person who reports fraud, so the reporter may not want to do so in a public way. This is not a good way to prevent fraud. An ethical corporate culture reduces the likelihood of fraud.

D.42

D.43

D.44

Incorrect

b. c.

Incorrect Correct

Incorrect

a. b.

Incorrect Incorrect

Correct

Incorrect

a, b, c d.

Incorrect Correct

By definition the reason to believe that a fraud has occurred is called predication. By definition the reason to believe that a fraud has occurred is called predication The Association of Certified Fraud Examiners indicates that assignments are initiated only with predication, which means that there is a reason to believe fraud may have occurred. By definition the reason to believe that a fraud has occurred is called predication The protection of evidence does not help establish a motive for a fraud. The dismissal of employees does not require documentation that has been protected. Protecting documents from damage and tampering establishes a chain of custody that establishes when and where the evidence was obtained and who had access to it. If the chain of custody is compromised, defense attorneys may argue to have the evidence thrown out of court under the grounds that it may have been tampered with or altered. The protection of evidence does ensure that the investigation is kept secret. To the contrary, the removal of original documents from files may indicate to an aware participant that an investigation is underway. See below. There are many types of environmental audits including (1) determining that waste material is properly documented, (2) ensuring that sufficient amounts have been accrued for existing environmental liabilities, and (3) ensuring that management is aware of environmental issues connected with the purchases of property or other business operations.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS D.45

Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal, and governmental audit situations. You might point out to students that the distinctions among compliance, economy and efficiency, and program results audits are not always clear. The ―solution‖ is shown in matrix form, showing some engagement numbers in two or three cells. The required schedule follows.

Type of Audit Kind of Auditor

Financial Statement

Independent CPA

b, j

Compliance

Economy, Efficiency

f, h

d, h

Internal auditor Governmental (GAO)

Program Results

a, c

IRS auditor

Bank examiner

a, c, i

(a) Proprietary school‘s training expenses

Economy and efficiency program results

Governmental (GAO)

(b) Advertising agency financial statements

Financial statement

Independent CPAs

Economy and efficiency or program results

Governmental (GAO)

(d) Municipal services

Economy and efficiency

Internal auditors

(e) Tax shelters

Compliance

IRS auditors

(f) Test pilot reporting

Compliance

Internal auditors

(g) Bank solvency

Compliance

Bank examiners

(h) Materials inspection by manufacturer

Compliance or economy and efficiency

Internal auditors

(i) States‘ reporting chemical use data

Program goal

Governmental (GAO)

(j) Sports complex forecast

Financial statement

Independent CPAs

D.46

Organizing a Risk Analysis TO: FROM: DATE: SUBJECT:

Senior Internal Auditor Director of Internal Auditing November 31, 20X1 Risk analysis of accounts receivable accounting

These questions are for your guidance. The Problem Total patient accounts receivable have increased steadily and rapidly for eight months. Our last audit of this area was 10 months ago. A favorable report is in the audit documentation. I can see no apparent reason for the increase because the number of beds, the occupancy rate, the billing rates, and the insurance contracts have not changed. What Financial/Economic Events Have Occurred in the Last 10 Months? 1. 2. 3. 4. 5.

Who Does the Accounting? 1. 2. 3.

Are new people doing the accounting? Who is the accounting manager now? Did employees give reasons for resigning?

What Data Processing Procedures and Policies Are in Effect? 1a. 1b. 2a. 2b. 3a. 3b. 3c.

How Is the Accounts Receivable Accounting Done? 1. 2.

Has the accounting been put on computer within the last 10 months? How many employees handle the accounting? Computer ______________________ Noncomputer ___________________

D.47

Study and Evaluation of Management Control TO: FROM: DATE: SUBJECT:

Internal Audit Staff Senior Internal Auditor July 31, 20X1 Comparison standards for study and evaluation of management risk mitigation control policies

To audit the performance of management controls, you will need to know quantitative standards of acceptable performance. Standards for two policies are described in this memo. 1.

Control: Sales are billed to customers accurately and promptly. (a)

Accuracy (a) Policy standard: No more than 3 percent of the sales invoices are figured with errors of either quantity or unit price or extension error amounting to over $1 per invoice. (2)

Audit procedures: 



Audit for completeness by selecting a sample of shipping documents and tracing to recorded sales invoices.



Audit for accuracy (related to shipping quantities, primarily) by confirming a sample of customers‘ balances (or individual unpaid invoices) and look for customer disagreements.

Promptness (1)

Policy standard: Sales invoices are to be entered in the sales journal and in customers‘ accounts with a (mailing) date no later than one day after shipment.

(2) Audit procedure: Using the samples in audit procedures (a.1) and (a.2), compare the sales journal record date and the date shown in customers‘ accounts with the shipment date. Document the number and extent of time lags exceeding one day. Inquire about the mailing date. (Memo, page 2 follows)

2. Control: Accounts receivable are aged and followed up to ensure prompt collection. (a)

Accounts receivable aging: (1) Policy standard: A complete and accurate aged trial balance is prepared monthly showing receivables in categories (a) current, (b) 31-59 days overdue, (c) 60-89 days overdue, and (d) more than 90 days overdue. (2) Audit procedures:



Inspect the aged trial balances to determine whether they were actually prepared each month.



Audit for completeness by comparing the trial balance total to the general ledger control account. (Foot each if necessary.)



Follow-up for prompt collection: (1)

Policy standard: Credit department personnel are supposed to receive the trial balance within five days after each month-end, and send different letters within five business days of receiving the aged trial balance for accounts as they become longer overdue, and turn accounts over to an outside collection agency when they are more than 90 days past due. After 60 days, further credit is cut off and customers are put on a cash basis.

(2)

Audit procedures:



For a sample of past due amounts in different months, inspect copies of the letters sent to customers and (a) observe whether the right standard letter was sent and (b) the date. Document exceptions to type of letter and mailing delay.



Inspect correspondence relevant to determining date that more than 90-day accounts were turned over to an outside agent.



Inspect notices of credit cutoff for customers with more than 60-day balances and inspect the trial balance for evidence of new credit mistakenly extended to such customers.



Using the sample from the second bullet point, verify the accuracy of the subsequent collections report prepared by the credit department by vouching the data therein to cash receipts records.

D.48

Quality Control Audit of a University a.

Answers to this question will vary but may include:        

Accreditation. Percentage of students going on to obtain advanced degrees. Percentage of students with jobs in their field. Percentage of students finishing in an allotted time (usually six years is used). Faculty publications. Textbooks written by faculty. Currency of curricula. Diversity of the student body.

Note: In all of these items, it is important to identify peer institutions that can establish both a norm and an aspirational target level as measurement criteria for the university‘s performance. The provost office, admissions and records, planning and placement, internal audit, and individuals‘ academic departments may all have information that pertains to the quality of the university. Some universities have an assessment office, which continuously looks at measures of performance for the school. b.

Measuring the quality of the items listed in part (a) is often difficult. Useful audit evidence to look for would include surveys of students, alumni, employers, and faculty. In addition, reviews of curricula and programs by prominent professionals in the workplace and faculty from other institutions may be useful. Records and registration should have evidence regarding retention of students and graduation rates. Placement offices should be able to provide information concerning employment of students. Final note: This problem should illustrate that in executing a performance audit, measurement criteria can be difficult to establish and the evidence needed to evaluate that measurement could be difficult to obtain.

D.49

Internal Audit of Inventory Note to Instructor: The data in the problem is based on a hypothetical electronics manufacturer with a mixed product line. The lines include computer games, personal computer add-ons (flash drives and semiconductor parts increased by smart phone and tablet sales) and a stodgy line of chargers and cables compatible with computers, tablets and smart phones. The trends for materials and parts category show modest efficiency improvement in turnover with an investment just large enough to dump the more dramatic ratio changes in the finished goods category. The trend for work-in-process category has shown a blip downward in 2016 with a slight increase in productivity level in 2017. Hypothetically, the company has current year sales of $10 million with cost of finished products sold amounting to $7.4 million for a 26 percent gross profit margin. You might tell students that the gross profit margin has not changed materially over the 2014-current year period, so they won‘t confuse the profitability variable with the inventory turnover ratio analysis. However, the condition of no overall change masks significant changes within the product lines.

A solution to the problem is presented on the following pages in the form of a memo summarizing the results of the analysis. Students should learn to think beyond the cranked-out numbers and write some interpretation of their meaning in relation to the economy and efficiency of the use of inventory assets.

Memo: Internal Audit of Inventory TO: FROM: DATE: SUBJECT:

Vice President, Production Internal Audit Manager January 10, 2019 Preliminary report: Analysis of inventory turnover

At the beginning of my economy and efficiency audit of inventory, I computed turnover ratios as follows. This preliminary report is for the purpose of alerting you to certain inventory investment conditions. I will set up a meeting with you to discuss your insights on the conditions and your suggestions for further work. Inventory Turnover for the Year 2017

2018

2019

2020

2021

Computer games

6.0

7.0

10.0

24.0

5.0

Flash drives

8.0

7.2

7.7

8.5

11.0

Semiconductor parts

4.0

3.5

4.5

7.0

10.0

Chargers and cables

3.0

2.5

2.0

1.9

1.8

Work in process

12.0

12.5

11.5

11.7

12.1

Materials and parts

4.0

4.1

4.3

4.5

4.0

Total inventory

2.1

2.0

2.1

2.5

Finished products:

Total inventory: Overall, inventory management appears to be under control. Turnover is a little better than in past years. However, the overall turnover masks specific conditions. Computer games: Competition has been deadly. Despite price-cutting, inventory increased by 31.5 percent from $380,000 to $500,000. The gross ―profits‖ turned into losses. This segment of inventory probably ought to be written down to a market value lower than the $500,000 cost. A question for investigation: Are production resources being used for games that could better be used for other products? Flash drives and semiconductors: The inventories have increased to keep up with sales demand. Increases were $236,000 (468 percent) for disk drives and $320,000 (500 percent) for semiconductor parts. Both rates of increase are exaggerated because of the small beginning inventories. Even with stable business next year, the turnover will probably decline because of the larger inventories. A question for investigation: How well do inventory holding and production plans match sales projections? These product lines may be vulnerable to a sharp decline like the one experienced in computer games.

Chargers and cables: The typewriter inventories have never had a high turnover. The inventory reduction of $88,000 (22 percent) appears to indicate more efficiency because sales volume declined by only 3 percent. A question for investigation: Can inventory be reduced still further without losing sales because of stock outs? Work in process: The production throughout appears to be efficient in terms of turnover, turnover improvement, and the level of inventory investment. The small inventory decline of $74,000 (11 percent) seems to be the product of increased efficiency over last year. A question for investigation: Do physical production records confirm the apparent efficiency, or is the improvement merely an artifact of timing (e.g., transferring goods that were almost-finished at 12/31/12 and working overtime to transfer goods at the end of 2013)? Materials and parts: The turnover is about in line with that in prior years, but the inventory declined by $745,000 (55 percent). Purchases of materials and parts were obviously lower in cost than last year. Questions for further investigation: Are some materials and parts in short supply? Has the reduced inventory created any subsequent production delays? Were beginning inventories merely bloated by a late 2012 stockpiling? Summary: Our next discussion should be fruitful. Your knowledge of production conditions will help direct the internal audit effort related to the questions raised in this memo.

Roster Turnover = Cost of Goods Sold / Average inventory —————-> Must be done for each category of inventory

Total Inventory Materials and parts Work-in-process Computer Games Flash drives Semiconductor parts Chargers and cables

Beginning Inventory

Ending Inventory

Average Cost of Goods Inventory Sold for Category

3000

2917

2958.5

7400

2200+2000+2400+800

2.5

7400/2958.5

1365 623 380 64 80 488

620 697 500 300 400 400

992.5 660 440 182 240 444

3970 7988 2200 2000 2400 800

Given in problem Given in problem Given in problem Given in problem Given in problem Given in problem

4.0 12.1 5.0 11.0 10.0 1.8

3970/992.5 7988/660 2200/440 2000/182 2400/240 800/444

COGS Calculation

Inventory Turnover Inventory Turnover for Category Calculation

Note: The cost of goods sold for (1) materials and parts and (2) work-in-process is the value of transfers out

D.50

Internal Auditors in the Fast-Food Industry

Risk (part a)

How Risk Could Affect McDonalds (part b)

How the Risk Affects Internal Audit (part c)

Competition—not only the risk of direct competition such as Burger King and Wendy‘s exists but also of other fast-food chains such as Subway and Taco Bell, other restaurant chains such as Applebee‘s and Fridays, local restaurants, and stay-at-home convenience foods.

McDonalds sales could be affected by new campaigns from existing restaurant chains (from a partnership with a movie, or a new food product) or new entrants into the marketplace.

Internal audit must determine that marketing is continually evaluating the competition and providing relevant, reliable, and timely information to senior management.

Customer preference often changes to foods that provide different nutritional value or are trendier.

McDonalds has lost market share because many customers are looking for a healthier alternative. Subway has made major inroads into McDonald‘s market share because of this trend. Other consumer trends may pose a risk to McDonalds.

Internal audit must determine that marketing is continually evaluating customer preferences and providing relevant, reliable, and timely information to senior management.

The economy is an area that all businesses must evaluate. Changes in the economy can change customer buying habits and product preferences.

While McDonalds is not likely to suffer greatly in an economic recession, some individuals may opt to stay at home. Local economic conditions, such as the closing of major factories or military facilities, can have a great economic impact on a community and on McDonalds‘ franchises in these areas. The price of commodities, such as gasoline, can influence consumer behavior and affect McDonalds.

Internal audit must determine that management is evaluating the economy. This includes district managers reviewing economic conditions and events that may impose a risk to the corporation and its franchises. Internal audit must ensure that lower levels of management provide relevant, reliable, and timely information to senior management.

How Risk Could Affect McDonalds (part b)

How the Risk Affects Internal Audit (part c)

Technology is a risk in both production and consumer behavior.

Restaurants, especially fastfood restaurants, rely heavily on technology for cooking and processing orders. When a competitor can implement a technology and lower its cost, the competitor obtains an advantage. In addition, providing consumers access to technology, such as at cyber cafes, may provide a competitive advantage to those that implement this technology.

Internal audit must be aware of new technologies in the fast-food industry and ensure that engineering is evaluating its impact on the corporation and its franchises. Internal audit must ensure that information on new technologies is provided to senior management. Marketing must include the desire for technology in its customer evaluation (see point 2).

Restaurants of all types are heavily regulated. Health laws at the federal, state, and local level must be known and followed. Labor laws, especially where employees under 18 are used, must also be followed.

Many of these regulations change on a frequent basis. A violation such as health issues at one restaurant may affect many locations because of the adverse publicity.

Internal audit must provide a comprehensive program to ensure that franchises and company-owned restaurants are following laws and regulations. This will include auditing the department responsible for compliance and inspections. Internal audit must ensure that information about regulatory and legal compliance is provided to senior management.

Other risks that may need to be identified pertain to weather, supply chains, and labor markets.

These risks may vary depending on location and the nature of the risk.

Internal audit would ensure that appropriate departments are reviewing the potential risks so that they are identified and controlled and that information regarding the risks is provided to senior management.

Risk (part a)

D.51

CPA Involvement in Expanded-Scope Audit a.

The financial and compliance audit work should determine:

(1) The financial statements are presented in conformity with GAAP or another comprehensive or required basis of accounting. (2) GAAP has been applied consistently. (3) Disclosures in the financial reports are adequately informative. (4) The program management maintains effective internal accounting control. (5) The program and its management are complying with applicable laws and regulation. b.

The CPAs should try to find standards for evaluating uneconomical or inefficient practices in areas such as these:

(1) Purchase of food commodities in more expensive small packages instead of in less-expensive bulk quantities. (2)

Employment of more people than necessary to accomplish the purposes of the program.

(3) Unnecessary investment in trucks or other equipment when alternative means would be less costly. (4)

Failure to coordinate administrative practices with regional offices (if any).

Standards for judging program results: (1)

Sources  Legislation.  Legislative committee reports.  Department of Agriculture regulations, orders and rulings.  Contractual or grant proposal statements of objectives.

(2)

Standards may relate to  Number of institutions or people served.  Cost savings compared to market prices of foodstuffs.  Quality of food distributed.  Timeliness of distribution.  Improvement in hunger-related statistics.

D.52

Selection of Effective Extended Procedures a.

The procedures are: (1)

(2)

Take a surprise count of the petty cash on Friday afternoon or Monday morning and compare the result with the recorded fund balance. Review cash receipts.

(3) Perform some analytical procedures. For example, compare the balance of the petty cash fund for this year with that for the previous years. If there is significant discrepancy, additional investigation is needed. (4) Verify whether there is change in the policy or procedures for petty cash fund. If not, investigate whether there is change in the custodian‘s life style. b.

The procedures are:

(1) Identify the existence of the newly approved vendors. For example, check with the Secretary of State‘s office, check the telephone book, or search the Internet to find information about those vendors. If all or some of the vendors do not exist, perform the following: (a) Determine the extent of the potential fraud. Review cash disbursements journal and accounts payable records to look for checks written to those vendors. (b) Examine vouchers package to see if the supporting documents are complete. (c) Retrieve checks paid to those vendors and examine the endorsement on the checks. If there is a pattern in the endorsement, implement (d). (d) Consult with the company attorney regarding how to proceed.. c.

The procedures are: (1) Observe the distribution of paychecks and verify with the superintendents that the persons indicated on the unclaimed checks are no longer employees. (2) Observe where the unclaimed paychecks go. If the unclaimed checks go to the payroll supervisor, then continue with (3) & (4). (3) Examine the procedures of reporting and excluding nonemployees. (4) Examine the file of paid checks to look for the unclaimed paychecks. Examine the endorsement of the checks. If there is a pattern in the endorsement, then continue with (5). (5) Consult with the company attorney regarding how to proceed.

The procedures are: (1) Observe the counter clerks opening the mail. (2) Take analytical procedures for accounts receivable write-offs. If there are no significant changes in the write offs, then (a) Count envelopes received and compare the result with the number of cash receipts recorded in the prelist. If there is discrepancy in the results, then •

Consult with the company attorney regarding how to proceed..

The procedures are: (1) Obtain bank statements for several months. Compare each day‘s deposit with cash receipts journal. If there is a pattern in the time difference between each day‘s deposit and cash receipts journal, then (a) Consult with the company attorney regarding how to proceed.

D.53

Internet Exercise: Audit charters a-e.

D.54

D.55

Answers will vary depending on the college or university chosen.

Internet Exercise: Government Audit Reports a.

Answers will vary depending on the CAFR chosen by the student.

Students should recognize that the report on the CAFR has the same basic structure as the threeparagraph audit report. The financial statements have different names because a government does not have income. There is no reference to the PCAOB because governments are not subject to those laws.

There are usually several paragraphs referring to other information included in the CAFR.

Collecting Evidence in a Fraud Examination a. The fraud examiner has four main objectives in performing a fraud audit. First, the fraud examiner must determine whether a fraud does exist. Second, once the determination that a fraud does exist is made, the examiner must determine the scope of the fraud. The fraud examiner must attempt to determine when the fraud started and the amount of money that has been misappropriated. Third, the fraud examiner must identify the perpetrators, taking great care not to falsely accuse employees and not to solicit help from management personnel who might be involved in the fraud. Finally, the examiner must determine how the fraud occurred and whether changes in controls or policy can eliminate this type of fraud in the future. b.

The fraud examiner can obtain the written customer return forms as evidence because there are handwritings on the forms and it is easy to find a pattern in the writing. This evidence is helpful in determining the existence of a fraud and identifying the perpetrator. The fraud examiner can also obtain the cashier‘s registry journal as evidence because there is information concerning who made the transactions when and in what amount. This evidence is helpful in determining the scope of the fraud.

D.56

The fraud examiner should make copies of the evidence and seal the original documents in a plastic bag with her or his signature and date. Sometimes the fraud examiner needs to take photographs of certain items.

Auditing the Effectiveness of a Loan Program TO:

Chief, Mega City Field Office U.S. General Accounting Office

FROM:

(Name), GAO Manager Office of Economic Opportunity Audits

DATE: SUBJECT:

Mega City Special Impact Loan Program—Specific Steps for Evaluation of Program Effectiveness

The Office of Economic Opportunity (OEO) designed the Special Impact Programs to have a major impact on unemployment, dependency, and community tensions in urban areas with large concentrations of low-income residents. Our evaluation of program effectiveness must comprehend the OEO goals of (1) creating training and job opportunities, (2) improving the living environment, and (3) encouraging development of local entrepreneurial skills. More specifically, in terms of the Mega City programs, we need to evaluate programs designed to (1) stimulate private business, (2) improve housing, (3) establish community facilities, and (4) train residents in marketable skills. Our initial evaluation emphasis will be on the two programs to stimulate private business. One program involved loan and equity financing to local businesses. The other involved an advertising program to attract outside businesses in the area. Define the program goals: A.

Preliminary Survey—Loan and Equity Business Financing We need to determine what goals have been set so we can use them as standards against which measurements of actual results can be compared. Our initial information is that the sponsors proposed to create 1,700 new jobs during the first four years of the loan program by making loans (later, equity investments) to about 73 new and existing businesses. The first specific work will be a study of authorizing and enabling rules, regulations, and proposals that will give us information about performance standards. A staff member will read and extract relevant excerpts from: 1. 2. 3. 4. 5. 6.

Legislative history documents (committee reports, OEO rules, regulations and directives). Grant applications/proposals made for private funds. Mega City program planning papers and internal memoranda. Internal audit reports, if any. Interviews with program administrators. Grant contracts, if any.

Preliminary Survey—Advertising Program To determine measurable objectives, the staff member can use the sources listed above. I suspect, however, that given the nature of public relations and advertising programs, the most specific statements of objectives will be obtained from internal planning papers and memos, internal audit reports, and interviews with administrators.

Prepare a summary in the detail necessary to specify measurements relevant to each objective. This summary will be our ―lead schedule‖ for organizing the work. Our preliminary information indicates the following should appear in the summary: 1.

2. 3. 4. 5.

Number of advertisements a. Radio. b. Television. c. Newspapers. Number and location of neighborhood centers active in the program. Extent and number of consultants in the management assistance division. Number of jobs objective: 1,700 in four years. Number of businesses financed in whole or in part: 73.

Evaluate management control: A.

Perform a complete review 1. 2. 3. 4.

Obtain an organization chart. Document the procedures for processing loan applications. Document loan repayment follow-up procedures. Document equity investment management and participation procedures.

Perform compliance auditing 1.

Select a sample of loan applications, both accepted and rejected, and determine whether their handling conformed to acceptable management control policies.

Obtain reports, memos, or other documents concerning participation as equity investors, and determine whether the actions conformed to acceptable management control policies.

In connection with program accomplishment work described below, determine whether acceptable loan repayment follow-up procedures were performed in accordance with management control policy.

Regarding compliance, determine whether any major features of management control (or lack thereof) point to probability of violation of regulations or grant terms.

Loan/Equity program—Evidence:

Obtain or prepare schedules of loans made during the four-year period, showing 1. 2. 3. 4. 5.

Name of applicant. Date of application. Date and terms of loan(s). Number of jobs attributed to the financing. Repayment history.

Confirm outstanding loans with debtors.

Visit loan recipients and obtain firsthand information about jobs, success/failure, and effect of financing and new or existing business.

Compare summary totals of dollars, jobs, businesses to loan program objective standards.

Schedule similar information pertaining to equity investment.

Inspect stock certificates or other evidence of investment.

Advertising program—Evidence:

D.57

Obtain or prepare a chronological schedule of the frequency and cost of radio, television, and newspaper advertisements and of the cost of advertising materials.

Vouch costs to supporting bills, invoices, contracts, and canceled checks.

Compare these input data to standards for frequency, media, and cost.

Prepare a schedule associating loan application and equity financing application activity with the timing of major advertisings. (Attempt to assess the effect—output—of the advertising efforts.)

Operational Audit: Customer Complaints a.

The problem lies in the fact that several departments must perform their functions before the customer‘s check or credit notice is processed. The company made the promise of promptness but did not set up any procedures for achieving it. Analysis of time lags: Buyers‘ examination and report preparation .......................................... Customer Relations Department approval ............................................. Accounting Department weekly batch processing (five days when the receipt arrives on the first day of the week) ..................... Check approval by treasurer ................................................................. Total (not considering time lag involved in waiting to send monthly statement for notice of credit)...........................................

2–3 days 2–3 days 2–5 days 2–3 days 8–14 days

Recommendation report: TO:

Larry McMurray, President Sally Godwin, Director of Customer Relations

FROM:

Danny Deck, Director of Internal Auditing

DATE:

Monday

SUBJECT:

Timely response for merchandise return credits

The problem Larry informed me of the level of complaints from customers about waiting too long for us to fulfill our promise of ―prompt credit when you change your mind.‖ Even though we made the promise, we established no expediting procedures to meet the goal of sending a check or a credit notice within five working days. I selected a sample of credit memos and found the time lag to average 10 days with a range of 8 to 14 days between the date on the returned merchandise receipt and the date on the refund check. There is no provision at all for sending a credit on account notice before the next mailing of monthly statements, so the delay waiting until the next monthly statement may be even longer. Recommendations The returned merchandise receipt does not need to follow the path to the buyers, then to Sally‘s department for approval, and thence to accounting. We can cut four to six days by having the clerks send them directly to accounting. A copy can be used for the other work without interfering with the time schedule. The accounting department needs to either (a) process returns daily instead of waiting for a weekly batch to accumulate or (b) set up a special, perhaps manual, check-writing and credit memomailing procedure. A manual procedure is appealing because (a) it will give customers the knowledge that their problem is not ―being run through the computer,‖ (b) checks and credit notices will be mailed within five days, and (c) it may cost less than rearranging the computer processing schedule. As an alternative, we could set up a special desk for immediate cash refunds. The clerks could send the merchandise and the returned merchandise receipt to the desk, where we could make a show of handing over the cash. The cash fund could enter the accounting system like another petty cash fund, and all the data processing will fit in our established system of control and data processing. After the customer is satisfied, we could perform all the procedures now specified and achieve control by monitoring the transactions after they are completed. D.58

GAO Auditor Independence With respect to potential impairment of independence, the GAO auditor might be in a position similar to that of the independent auditor of financial statements who makes a recommendation to a client for improving internal control. Alternatively, the GAO audit recommendations may be more in the nature of suggestions similar to those made in a consulting service engagement (that is, having an effect beyond technical internal control procedures).

The potential for impairment of independence results from the possibility of having to audit the subsequent implementation or better enforcement of contract requirements and development of a master car-testing plan by the management of the Washington Metropolitan Area Transit Authority. Because the GAO made these recommendations, they could be perceived as auditing ―their own work‖; however, the implementation effort is not their own work. A lack of independence would result if the same or different GAO auditors in a subsequent audit were reluctant or failed to find fault because they had been involved with the earlier recommendations for improvement. Assigning subsequent audit work to different personnel can create a stronger perception of independence. The ways in which the GAO can resist impairment of independence are essentially the same as those of the independent external auditor: the GAO auditor (1) should absolutely refrain from making management decisions and (2) should remain alert to his or her professional and ethical responsibility to conduct the audit in accordance with established auditing standards.

D.59

Efficiency Standards The hint should give away an answer. The USPS measured the delivery lag time from the moment mail reached the sending post office and was postmarked (ignoring the pickup and local transportation time) to the moment the mail reached the destination post office (ignoring the local delivery time lag). The customer focus sees the time interval from the moment the customer puts mail in the local pickup box (perhaps after the last pickup of the day—ignoring the unknown operation of delivery to the local post office for postmarking and processing) to the moment the mail reaches the hands of the recipient (including local transportation and delivery schedules).

D.60

The Perfect Crime There are ways in which the fraud may be detected. a.

The vouchers function in the treasury department can detect the crime. If all of the vouchers package are canceled after each payment, when the embezzler prepares for a second payment for the same invoice, the scheme will be found because there are no supporting documents.

An internal auditor who performs bank reconciliation may detect the fraud. In addition to check numbers and amounts indicated in the bank statement, the reconciler should also acquire information such as payee from the bank. Such information will help the reconciler to detect the fraud.

Although the paid checks are not returned to the company, the company can ask the bank to be cooperative in a reverification of the signature. The rubber stamp used by the accounts payable clerk can be detected in this way.

Extensive detection efforts are as follows: a. b. c. d.

Ask the bank for information about payees, especially for checks with the same amount. Retrieve vouchers for payments with the same amount. Examine the supporting documents. Confirm with the vendors concerning the time and amount of payments. Consult with the company attorney to obtain a subpoena for the bank records (original paid checks).

D.61

D.62

Impact of Changing Rules a.

When a company outsources its internal audit function to a CPA firm, it gains expertise and improves control over audit costs.

When a CPA firm provides internal audit services to its audit client, the biggest concern is whether the CPA firm can keep its independence as required by the profession. When evaluating the company‘s internal control for planning the audit of financial statements, the CPA is actually assessing his or her own work. Financial statements users doubt that the CPA can keep objectivity and integrity under such a circumstance.

This is a discussion question, and students‘ answers may vary, including the following: 

The requirement in the Sarbanes-Oxley Act that CPA firms should not perform internal audit services to their audit clients but should be allowed to provide such services to nonclients. Concerning the independence issue, CPAs should be independent in both substance and appearance.



When external auditors evaluate the clients‘ internal control, they are familiar with the control condition, especially the weaknesses. Therefore, if external auditors provide internal control services to their clients, such services are targeted and timely.



When external auditors evaluate the clients‘ internal control, they focus on the aspects related to financial statements. However, internal control includes other important aspects, such as compliances, effectiveness and efficiencies, and so forth. Therefore, if external auditors provide internal control services, such services tend to be imbalanced and may not work for the client‘s best interest.

Looking for Evidence of Fraud a.

It is unlikely that this invoice is legitimate. The following red flags provide questions about the invoice. 

Invoices are usually sent through the mail and therefore show signs of mailing. The fact that there are no creases is a red flag that this was received without mailing.



Invoices are approximately a month apart and always show up at the same time each month.



Invoices are a month apart but are only a few numbers apart. This indicates there are few if any other customers and because the dollar values are relatively small, it is questionable whether this is a legitimate business.



The dollar values continue to increase with each month. When getting away with a fraud, the person often increases the dollar amounts trying to determine the level of fraud she or he can perform without being questioned.



The invoice mailing address is a post office (PO) box. While many companies use a PO Box for payments, the lack of any other address should still raise an issue.



There is no telephone number on the invoice. Most companies provide a telephone number in case there are questions about the invoice.



The item on the bottom ―payment is due immediately upon receipt‖ is unusual in a business relationship. Payment terms usually provide a period of time (e.g., 14 days, 30 days) and sometime have terms (e.g., 2/10, net 30)

The most likely fraud involves a shell company. Someone creates a company that does not really exist. The company may just provide invoices without ever providing any product if weakness in the system allow for a payment without receiving reports and other documentation. The company may also provide product, but at a substantial market up. In our example, the person who created Best Office Supply may be able to purchase copy paper for $9 per case. If the person is in purchasing or in collusion with someone in purchasing, he or she may be able to get an order at this higher dollar amount (at markup of 75 percent). The person purchases the paper and has someone deliver it to the company. All the documents (purchase order, receiving report, etc.) are now available for payment.

MODULE E Attributes Sampling LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises and Problems

Identify the objectives of attributes sampling, define deviation conditions, and define the population for an attributes sampling application.

1, 2, 3, 4

27, 28, 39

51, 53, 54, 55, 71 (*), 73 (*), 74 (*), 75 (*), 76 (*), 77 (*)

Understand how various factors influence the size of an attributes sample and how to determine the sample size for an attributes sampling application.

5, 6, 7, 8, 9

29, 30, 31, 32, 33, 34, 46

52 (*), 60, 61, 62, 63, 64, 71 (*), 72, 75 (*), 76 (*), 77 (*), 79 (*), 80

Identify various methods of selecting an attributes sample.

10, 11, 12

Evaluate the results of an attributes sampling application by

13, 14, 15, 16, 17, 18, 19, 20, 21, 22

56 (*), 57, 58, 59, 71 (*), 73 (*), 74 (*), 79 (*)

35, 36, 37, 38, 40, 41, 42, 43, 44, 45

52 (*), 56 (*), 65, 66, 67, 68, 69, 70, 71 (*),

determining the upper limit rate of deviation.

Understand how to use sequential sampling, discovery sampling, and nonstatistical sampling in attributes testing.

75 (*), 76 (*), 79 (*), 81

23, 24, 25, 26

47, 48, 49, 50

73 (*), 74 (*), 77 (*), 78

(*) indicates that an item corresponds to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS E.1

Attributes sampling is a form of sampling that is used to determine the extent to which some characteristic (attribute) exists within a population of interest. Attributes sampling is used by the audit team in performing tests of controls to determine the operating effectiveness of internal control policies and procedures.

E.2

The audit team‘s objective in attributes sampling is to determine the operating effectiveness of key controls that influence the financial statement assertions of interest. As a result, the financial statement assertions ultimately determine which control(s) are tested and are the subject of the audit team‘s attributes sampling application.

E.3

A deviation condition is a condition that refers to instances in which client personnel do not follow prescribed controls. Deviation conditions are important in an attributes sampling application because they provide the audit team evidence regarding the operating effectiveness of the client‘s internal control.

E.4

An appropriate definition of the population is important because the audit team‘s conclusions can be extended only to the population from which the sample is selected.

E.5

Sampling risk is the likelihood that the decision made based on the sample will differ from the decision that would have been made if the entire population had been examined, which is a sampling error.

Tolerable rate of deviation is the maximum rate of deviations permissible by the audit team without modifying the planned level of control risk.

The expected population deviation rate is rate of deviations anticipated by the audit team in the client‘s internal control policies or procedures.

The audit team determines sampling risk and tolerable rate of deviation judgmentally based on the planned level of control risk (if the planned level of control risk is lower, the sampling risk and tolerable rate of deviation should be lower) and the desired level of assurance. The audit team assesses the expected population deviation rate based on either prior experience with the client (for recurring engagements) or a small pilot sample of controls (for first-year engagements). E.6

The risk of underreliance (risk of assessing control risk too high) occurs when the audit team‘s sample indicates that the control is not functioning effectively when, in fact, it is. When this risk occurs, the audit team‘s adjusted sample rate of deviation exceeds the tolerable rate of deviation. However, unknown to the audit team, the true population rate of deviation is less than or equal to the tolerable rate of deviation. The risk of overreliance (risk of assessing control risk too low) occurs when the audit team‘s sample indicates that the control is functioning effectively when, in fact, it is not. When this risk occurs, the audit team‘s adjusted sample rate of deviation is less than or equal to the tolerable rate of deviation. However, unknown to the audit team, the true population rate of deviation exceeds the tolerable rate of deviation.

E.7

The risk of overreliance is more important than the risk of underreliance because overreliance risk may result in a less effective audit being performed. That is, the audit team may not perform a sufficient level of substantive procedures upon which to base the opinion on the financial statements.

E.8

E.9

Sample size has an inverse relationship with sampling risk; that is, as the acceptable sampling risk decreases, sample size increases.

Sample size has an inverse relationship with the tolerable rate of deviation; that is, as the tolerable rate of deviation decreases, sample size increases.

Sample size has a direct relationship with the expected population deviation rate; that is, as the expected population deviation rate increases, sample size increases.

In an attributes sampling application, the sample size is determined as follows: •

Based on the acceptable level of the risk of overreliance, select the appropriate sample table size.

•

Identify the row of the table corresponding to the expected population deviation rate for the control being examined.

•

Identify the column of the table representing the assessed tolerable rate of deviation for the control being examined.

•

Determine the sample size by identifying the junction of the row from the second bullet point and the column from the third bullet point.

E.10

When selecting sample items, the audit team should take steps to ensure that the sample is representative of the population from which it is drawn. For example, the audit team should select potential applications of control activities performed throughout the year, performed for larger and smaller dollar amounts, performed by different individuals, and related to transactions with different parties or individuals in different geographic areas.

E.11

Tests of controls are procedures performed by the audit team to determine the operating effectiveness of the client‘s key internal controls. The audit team‘s goal in performing tests of controls is to determine the rate at which the client‘s controls are not functioning as intended, or the sample rate of deviation.

E.12

If the audit team is unable to find an item that provides evidence of the client‘s performance of a control, it classifies that item as a deviation.

E.13

The sample rate of deviation is the rate of deviations from key controls noted by the audit team in the sample. It can be calculated by dividing the number of deviations by the sample size.

E.14

The ULRD is an adjusted rate of deviations that provides a conservative measure of the population rate of deviation. This measure allows the audit team to control the exposure to sampling risk to acceptable levels. The ULRD is the rate of deviation that has a (1 minus the risk of overreliance) probability of equaling or exceeding the true population rate of deviation. Conversely, there is a (risk of overreliance) probability that the true population rate of deviation exceeds the ULRD.

E.15

The ULRD is determined based on the risk of overreliance, sample size, and number of deviations. Because the sample size and number of deviations determine the sample rate of deviation, the ULRD is essentially based on the sample rate of deviation and the risk of overreliance.

E.16

The ULRD is determined as follows:    

Based on the acceptable risk of overreliance, select the appropriate evaluation table. Read down the ―sample size‖ column to find the row representing the appropriate sample size. Identify the column corresponding to the number of deviations found by the audit team. The ULRD is the value found at the intersection of the row in the second bullet point and the column in the third bullet point.

E.17

If the sample size examined by the audit team is not included in the AICPA sample evaluation tables, the audit team could (a) select additional items for examination to provide the next highest sample size included on the tables, (b) evaluate the results of the sample using a smaller (more conservative) sample size, or (c) interpolate the table values and estimate a ULRD for the number of items examined.

E.18

Because the sample rate of deviation is 6 percent (6 deviations  100 items = 6 percent) and the ULRD is 10.3 percent, the allowance for sampling risk is 4.3 percent (10.3 percent – 6.0 percent = 4.3 percent).

E.19

If the ULRD is less than or equal to the tolerable rate of deviation, the audit team would conclude that the control is functioning effectively. If the ULRD is more than the tolerable rate of deviation, the audit team would conclude that the control is not functioning effectively.

E.20

If the ULRD is less than or equal to the tolerable rate of deviation, the audit team can choose to rely on internal control at planned levels.

E.21

If the ULRD is greater than the tolerable rate of deviation, the audit team can reduce the reliance on internal control and increase control risk with a corresponding reduction of detection risk and increased substantive testing, or the audit team can expand the sample to achieve an observed ULRD less than or equal to the tolerable rate of deviation. However, expanding the sample is generally not an effective response.

E.22

Information that is typically documented in an attributes sampling application includes: 

Information on the objective of sampling, definition of deviation conditions, and definition of the population from which the sample was selected.



The risk of overreliance, tolerable rate of deviation, and expected population deviation rate, along with the rationale for these assessments.



The sample size determined based on the preceding factors.



Information on the selection of sample items and a list of items selected and examined by the audit team.



Results of the tests of controls performed on each item selected.



Information regarding the number of deviations and the ULRD.



The audit team‘s conclusion with respect to the operating effectiveness of the control and implications of this operating effectiveness on the audit team‘s reliance on internal control and substantive procedures.

E.23

Sequential sampling is a sampling plan in which an initial sample is selected and the audit team (1) draws a final conclusion regarding the effectiveness of the control or (2) selects additional items before drawing a final conclusion regarding the effectiveness of the control. It is often called stop-or-go sampling. The primary advantage of sequential sampling is that it may allow the audit team to form a conclusion on internal control with a relatively small sample size. The primary disadvantage of sequential sampling is that the allowable rate of deviations in the sample is lower than that in a fixed sampling plan (i.e., sequential sampling is more conservative). In addition, sequential sampling may ultimately result in the audit team‘s examining an extremely large number of items if they decide to expand the sample.

E.24

Discovery sampling is a form of attributes sampling that audit teams use when deviations from controls are very critical but are expected to occur at a relatively low rate, and the expected population deviation rate is set to zero. Discovery sampling should be used when a control is extremely important for the audit team‘s examination or when the audit team is suspicious of the existence of fraud.

E.25

Step 5, selecting the sample, may be performed differently for nonstatistical sampling than for statistical sampling. Because nonstatistical sampling does not use tables based on probabilities, the sample is not required to be selected randomly. Haphazard or block selection may be used as well as random or sequential selection. However, step 7, evaluating sample results, is where the primary difference between the two methods arises. Under statistical sampling, the allowance for sampling risk can be calculated with a known probability. Under nonstatistical sampling, the allowance for sampling risk is determined by auditor judgment. Step 4, determining sample size, would be different in that the audit team might not use the sampling tables or a computer program; however, the results should be similar.

E.26

The audit team first calculates the sample rate of deviation. If the sample rate of deviation is more than the tolerable rate of deviation, the audit team can conclude that the control is not working effectively and revise the planned detection risk. However, if the sample rate of deviation is less than tolerable rate of deviation, the audit team cannot conclude that the control is operating effectively. The audit team must use professional judgment to estimate the allowance for sampling risk to determine the likely rate of deviation in the population.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS E.27

E.28

a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

a. b. c. d.

Correct Incorrect Incorrect Incorrect

Determining preliminary levels of materiality is related to variables sampling. Attributes sampling selects occurrences of key controls for the audit team to examine using tests of controls. Substantive procedures are related to variables sampling. Searching for the possible occurrence of subsequent events is not an example of sampling. Identifying key controls is necessary when determining the objective of sampling. Prior to defining a deviation condition, the key controls must be identified. Prior to defining the population, the key controls must be identified. Prior to determining the sample size, the key controls must be identified.

E.29

a. b.

Incorrect Correct

Incorrect

Correct

Incorrect

The audit team does not control the risk of underreliance in an attributes sampling application. The audit team does not control the risk of underreliance in an attributes sampling application; however, the audit team does control the risk of overreliance. The audit team does not control the risk of underreliance in an attributes sampling application; however, the audit team does control the risk of overreliance. The audit team controls the risk of overreliance in an attributes sampling application.

E.31

a. b. c. d.

Incorrect Incorrect Correct Incorrect

Both sampling risks result in incorrect decisions by the audit team. The risk of underreliance is related to the study and evaluation of internal control The risk of overreliance may result in the failure to control audit risk to acceptable levels. Performing tests during an interim period does not influence the risk of overreliance.

E.32

NOTE TO INSTRUCTOR: Because this question asks students to identify the statement that will not result in an increased sample size, the response labeled ―correct‖ will not result in an increased sample size, but those labeled ―incorrect‖ will result in an increased sample size.

E.30

E.33

The tolerable rate of deviation has an inverse relationship with sample size. The expected population deviation rate has a direct relationship with sample size; the tolerable rate of deviation has an inverse relationship with sample size. The expected population deviation rate has a direct relationship with sample size; the tolerable rate of deviation has an inverse relationship with sample size. The expected population deviation rate has a direct relationship with sample size.

a. b. c. d.

Incorrect Correct Incorrect Incorrect

Reducing the risk of overreliance will result in a larger sample size. Increasing the tolerable rate of deviation will reduce (not increase) the sample size. Increasing the expected population deviation rate will result in a larger sample size. Increasing the tolerable rate of deviation will reduce (not increase) the sample size; as a result, choice (b) will not result in a larger sample size.

a. b. c. d.

Incorrect Incorrect Incorrect Correct

From the AICPA sampling tables, the sample size is 195. From the AICPA sampling tables, the sample size is 195. From the AICPA sampling tables, the sample size is 195. From the AICPA sampling tables, the sample size is 195.

E.34

Incorrect

Correct

E.35

a. b. c. d.

Incorrect Incorrect Incorrect Correct

From the AICPA sample evaluation tables, the ULRD is 6.9 percent. From the AICPA sample evaluation tables, the ULRD is 6.9 percent. From the AICPA sample evaluation tables, the ULRD is 6.9 percent. From the AICPA sample evaluation tables, the ULRD is 6.9 percent.

E.36

a. b.

Correct Incorrect

Incorrect

This is the correct interpretation of the ULRD. The probability that the actual rate of deviation in the population is lower than the ULRD is (1 minus the risk of overreliance). The ULRD does not provide an estimate with certainty; in addition, the probability that the actual rate of deviation in the population is lower than the ULRD is (1 minus the risk of overreliance). The ULRD does not provide an estimate with certainty.

Incorrect

Correct

E.37

Risk of overreliance increases as control risk increases; as a result, a 1 percent risk of overreliance cannot logically be associated with a control risk of 0.80. Risk of overreliance increases as a function of control risk; as a result, a 10 percent risk of overreliance cannot logically be associated with a control risk of 0.20 if a 1 percent control risk is assigned to a control risk of 0.50. Risk of overreliance increases as a function of control risk; as a result, a 10 percent risk of overreliance cannot logically be associated with a control risk of 0.50 if a 5 percent risk of overreliance is assigned to a control risk of 0.80. Risk of overreliance increases as control risk increases; this series is consistent with this relationship.

Without knowledge of the risk of overreliance, it is impossible to calculate the ULRD for a sample of 100 transactions with one deviation. Different levels of the risk of overreliance would result in different assessments of the ULRD. Without knowledge of the risk of overreliance, it is impossible to calculate the ULRD for a sample of 100 transactions with one deviation. Different levels of the risk of overreliance would result in different assessments of the ULRD. Without knowledge of the risk of overreliance, it is impossible to calculate the ULRD for a sample of 100 transactions with one deviation. Different levels of the risk of overreliance would result in different assessments of the ULRD. Without knowledge of the risk of overreliance, it is impossible to calculate the ULRD for a sample of 100 transactions with one deviation. For example, with a risk of overreliance of 5 percent, the ULRD is 4.7 and options (a), (b), and (c) would not allow the audit team to assess control risk at the appropriate level. However, if the risk of overreliance is 10 percent, the ULRD would be 3.9 and choice (c) would allow the audit team to assess control risk at the appropriate level.

E.38

E.39

E.40

E.41

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

a. b. c. d.

Incorrect Incorrect Incorrect Correct

Because the ULRD exceeds the tolerable rate of deviation, the audit team cannot support a control risk assessment based on the tolerable rate of deviation. The audit team should increase control risk because the ULRD exceeds the tolerable rate of deviation. Despite the fact that the ULRD exceeds the tolerable rate of deviation, the audit team can support a control risk assessment at less than the maximum level. Control risk should be increased, not decreased. Selecting customer accounts for confirmation as a part of the audit of accounts receivable would use variables sampling. Selecting inventory items for verification as a part of the audit of inventory would use variables sampling. Selecting purchase orders for indication of authorization is a test of controls that would use attributes sampling. Selecting additions to property, plant, and equipment for verification would use variables sampling. The audit team would compare the tolerable rate of deviation to the sum of the allowance for sampling risk and sample rate of deviation (not expected population deviation rate). In this example, the sample rate of deviation of 4 percent (5  125 = 4 percent) plus the allowance for sampling risk of 3 percent equals the ULRD (7 percent). Because the ULRD exceeds the tolerable rate of deviation of 5 percent, the audit team should assess a higher control risk. The expected population deviation rate is not considered in evaluating the results of the sample. The sample results would support a low control risk assessment if the sample rate of deviation plus the allowance for sampling risk is less than (not more than) the tolerable rate of deviation. From the AICPA sample evaluation tables, the ULRD is 12.8 percent. From the AICPA sample evaluation tables, the ULRD is 12.8 percent. From the AICPA sample evaluation tables, the ULRD is 12.8 percent. From the AICPA sample evaluation tables, the ULRD is 12.8 percent.

E.42

E.43

E.44

E.45

E.46

Incorrect

Correct

Incorrect

Correct

c. d.

Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

Incorrect

a. b.

Incorrect Incorrect

c. d.

Incorrect Correct

The audit team noted 7 deviations in the 90 items examined; therefore, the sample rate of deviation is 7.8 percent (7  90 = 7.8 percent). If the ULRD is 12.8 percent, the allowance for sampling risk would be 5.0 percent (12.8 percent – 7.8 percent = 5.0 percent). The audit team noted 7 deviations in the 90 items examined; therefore, the sample rate of deviation is 7.8 percent (7  90 = 7.8 percent). If the ULRD is 12.8 percent (see the answer to E.41), the allowance for sampling risk would be 5.0 percent (12.8 percent – 7.8 percent = 5.0 percent). The audit team noted 7 deviations in the 90 items examined; therefore, the sample rate of deviation is 7.8 percent (7  90 = 7.8 percent). If the ULRD is 12.8 percent (see the answer to E.41), the allowance for sampling risk would be 5.0 percent (12.8 percent – 7.8 percent = 5.0 percent). The audit team noted 7 deviations in the 90 items examined; therefore, the sample rate of deviation is 7.8 percent (7  90 = 7.8 percent). If the ULRD is 12.8 percent (see the answer to E.41), the allowance for sampling risk would be 5.0 percent (12.8 percent – 7.8 percent = 5.0 percent). The tolerable rate of deviation must exceed the ULRD for the audit team to rely on internal control as planned. The tolerable rate of deviation must exceed the ULRD for the audit team to rely on internal control as planned. The expected population deviation rate is not used in evaluating sample results. The expected population deviation rate is not used in evaluating sample results. Increasing the assessed level of control risk is an appropriate response, but the other alternatives are acceptable as well, making (d) the most appropriate response. Performing additional substantive procedures is an appropriate response, but the other alternatives are acceptable as well, making (d) the most appropriate response. Expanding the sample is an appropriate response, but the other alternatives are acceptable as well, making (d) the most appropriate response. Increasing the level of control risk, performing additional substantive procedures, or expanding the sample are all appropriate responses if the sample evidence does not support the planned level of control risk. The ULRD is the sum of the sample rate of deviation (not the expected population deviation rate) and the allowance for sampling risk. The ULRD is the sum of the sample rate of deviation (not the risk of underreliance) and allowance for sampling risk. The ULRD is the sum of the sample rate of deviation and the allowance for sampling risk. The ULRD is the sum of the sample rate of deviation (not the tolerable rate of deviation) and the allowance for sampling risk. The allowance for sampling risk is based on the allowable risk of overreliance. The expected population deviation rate is based on the audit team‘s experience in prior audits or a pilot sample of controls. The sample rate of deviation is based on the number of deviations and the sample size. The tolerable rate of deviation is based on the audit team‘s reliance on internal control.

E.47

E.48

E.49

E.50

a. b. c.

Incorrect Incorrect Correct

Incorrect

Correct

c. d.

Incorrect Incorrect

Incorrect

Correct

Incorrect

c. d.

Correct Incorrect

When using attributes sampling, the audit team determines a single sample size. When using discovery sampling, the audit team determines a single sample size. When using sequential sampling, an initial sample is selected and decisions related to expanding that sample are based on the results of the initial sample. When using statistical sampling, the audit team determines a single sample size. Although a form of attributes sampling would be appropriate, the low level of deviations and importance of ensuring that deviations occur at extremely low levels would make the use of discovery sampling more appropriate. Discovery sampling is used when the rate of deviations is anticipated to be low and the audit team desires a high level of assurance that deviations occur at a low rate. Sequential sampling would not be used in this situation. Although a form of attributes sampling would be appropriate, the low level of deviations and importance of ensuring that deviations occur at extremely low levels would make the use of discovery sampling more appropriate. Both statistical and nonstatistical plans require the audit team to define the appropriate characteristic of interest (key control to be relied upon). Both statistical and nonstatistical plans require the audit team to define the population (all occurrences of key controls to be relied upon). Both statistical and nonstatistical sampling require the audit team to measure the sample items by performing tests of controls. Nonstatistical sampling plans to not require the audit team to control their exposure to sampling risk when evaluating sample results. Auditing standards clearly state the sample sizes using nonstatistical sampling should be comparable to sample sizes from statistical sampling Audit teams must consider an allowance for sampling risk when using nonstatistical sampling. Using nonstatistical sampling is generally less complicated than statistical sampling. Because nonstatistical sampling will not necessarily result in a smaller sample size and requires the audit team to consider an allowance for sampling risk, this choice is not correct.

SOLUTIONS FOR EXERCISES AND PROBLEMS E.51

Test of Controls Objectives and Deviations a.

The credit department supervisor reviews each customer‘s order and approves credit by making a notation on the order. 1.

Objective: Determine whether credit is approved in accordance with company policy.

Deviation: Absence of notation of approval or disapproval on customers‘ orders.

The billing department must receive written notice from the shipping department of actual shipment to a customer before a sale is recorded. The sales record date is supposed to be the shipment date. 1.

Objective: Determine whether (1) written notices of shipment support recorded sales invoices and (2) the sales record date is the same as the shipment date.

Deviation: (1) Absence of written shipment notice and (2) sales record date and shipment date are not the same.

Billing clerks carefully identify the correct catalog list prices for goods shipped and calculate and verify the amounts billed on invoices for the quantities of goods shipped. 1.

Objective: Determine whether (1) quantities on shipping notices and invoices are the same, (2) unit prices on the invoices are correct and agree with catalog prices, and (3) invoices are arithmetically correct

Deviation: (1) Quantities on shipping notices and invoices do not match, (2) unit prices do not agree with catalog prices, and (3) Invoices include mathematical mistakes.

Billing clerks review invoices for intercompany sales and mark each one with the code 9 so that they will be posted in intercompany sales accounts. 1.

Objective: Determine whether invoices are properly coded for intercompany sales.

Deviation: (1) Invoice to an affiliated company not marked code 9 or (2) invoice to an outside customer marked code 9.

E.52

E.53

General Attributes Sampling a.

Holyfield has incorrectly identified the population. By identifying it as all invoiced sales and selecting sales invoices for examination, she will begin with a transaction that has been billed. The correct definition of the population if she wishes to verify that all shipments have been billed would be the population of shipping documents.

Holyfield‘s action in this situation is correct. The risk of overreliance should be established at lower levels when a higher degree of reliance on Top Rank‘s internal control is planned.

Holyfield‘s action in this situation is correct. Although prior audits provide a guideline for establishing the expected population deviation rate, she should consider any changes occurring since those audits. Although it is impossible to determine whether a 1 percent expected population deviation rate is appropriate, it is certainly reasonable to reduce the expected population deviation rate from that used in prior years if improvements in the processing of transactions have occurred.

Holyfield‘s action in this situation is partially correct. Although the initial sample size of 156 is appropriate for the parameters specified in the Top Rank engagement, it is not appropriate to adjust this sample size for the size of the population. AICPA sample size tables assume a large population in determining sample size. In addition, based on statistical theory, once a population reaches a certain size, increases in its size have a minimal effect on sample size.

Holyfield‘s action in this situation is incorrect The sum of the sample rate of deviation and allowance for sampling risk (the ULRD) should be compared to the tolerable rate of deviation, not to the risk of overreliance.

Examples of Deviations a.

Although not technically conforming to the control activity, the fact that some indication was placed next to the quantities suggests that this would not be classified as a deviation.

Professional standards are explicit in noting that a missing document should be classified as a deviation.

The fact that the invoice is marked as ―VOID‖ provides some evidence that the shipment was not made; accordingly, it does not appear that this would be classified as a deviation. However, the invoice should be replaced with another randomly selected invoice.

Although the quantities may have been properly checked, the fact that the check mark is not noted on an item-by-item basis may indicate that the employee hurriedly reviewed the invoice and did not perform the work. This would likely be classified as a deviation.

The fact that check marks were placed adjacent only to items located in the same location of the warehouse indicates that only these quantities were verified. Accordingly, this invoice would be classified as a deviation.

The fallacy in assuming that the controls relating to the remaining 95 invoices were being performed properly is that an employee could merely place a check mark on the invoice without reviewing the quantities (because of time pressure, lack of care, etc.).

E.54

Examples of Deviations a.

The following are the most common tests of controls that Perry could use for the particular control described. Other possible tests of controls are acceptable but would typically provide weaker evidence (for example, Perry could observe various controls related to documentary evidence, but inspecting the documentary evidence generally provides stronger support of the operating effectiveness of the control). 1.

Observe the segregation of duties or inquire of appropriate individuals as to the segregation of duties.

Inspect documentary evidence of approval of purchase orders by appropriate personnel.

Inspect documentary evidence of matching vendors‘ invoices to purchase orders by appropriate personnel.

Inspect documentary evidence of mathematical verification of vendor invoices by appropriate personnel.

For a sample of cash disbursements, identify an appropriately approved and mathematically verified vendor invoice.

Individual(s) performing incompatible duties of authorizing the purchase, preparing the purchase order, and receiving goods and services being purchased.

Failure of individuals verifying approval of purchases to include their initials on the purchase order.

Failure of individuals matching vendor invoices to purchase orders to include notation of the purchase order number on the vendor invoice.

Failure of individuals‘ mathematical verification of vendor invoices to include their initials on the invoice.

Existence of a payment for an unapproved vendor invoice.

This should be classified as a deviation. The fact that this was a ―one-time‖ occurrence does not compensate for the potential problems that arise when the individual who authorizes a transaction also receives custody of the goods and services related to the transaction. Although this procedure may have been necessitated because of urgency, another party could have received the goods and services.

This would likely not be classified as a deviation. In this particular instance, although the individual did not strictly comply with the control activity, her signature suggests that the purchase order was reviewed and appropriately verified.

The classification of this item is debatable. On one hand, the fact that the words ―OK, approved‖ were written suggests that client personnel reviewed the purchase order related to the vendor invoice. However, the fact that the specific purchase order number was not noted may indicate that the purchase order was not examined or was examined in a hurried manner. This would likely be classified as a deviation, primarily because the purchase order number was not included.

Professional standards are explicit in stating that a missing document should be classified as a deviation. Therefore, the failure to locate the vendor invoice should receive this classification.

This would not be classified as a deviation because Parker‘s personnel properly authorized each of the invoices included in the payment.

Once identified by Perry, the number of deviations (along with the acceptable level of the risk of overreliance and the sample size) is used to calculate the ULRD. The ULRD is then compared to the tolerable rate of deviation. If the ULRD exceeds the tolerable rate of deviation, Perry would conclude that the control is not functioning effectively and would therefore reduce the planned level of reliance on internal control and would increase control risk. If the ULRD is less than the tolerable rate of deviation, Perry would conclude that the control is functioning effectively, rely on internal control as planned, and maintain control risk at planned levels.

E.55

Examples of Deviations a.

A deviation is a condition that refers to instances in which client personnel do not follow prescribed controls. An example of a deviation from this control would be a sale processed to a customer without an approved credit authorization.

The audit team considers deviations in (1) determining the necessary sample size and (2) evaluating the sample results. In determining the necessary sample size, the audit team considers both the extent of deviations that are likely to be present in the population (expected population deviation rate) as well as the maximum rate of deviations permissible without modifying the planned reliance on internal controls (tolerable rate of deviation). In evaluating sample results, the audit team considers the number of deviations actually identified during the tests of controls as well as the tolerable rate of deviation.

Jones would select a sample of sales made to customers and verify the existence of a credit authorization.

Because these deviations were inadvertent mistakes and omissions, Jones would not have increased concern about these deviations beyond their impact on the ability to rely on the control activity. The fact that they were made by a number of different employees and occurred throughout the period indicates that they may be the result of careless behavior on the part of Hicks‘s employees and may suggest the need for an increased emphasis on important control policies by management.

Like (1), the inadvertent nature of these deviations does not increase Jones‘s concern about the deviations beyond their impact on his ability to rely on the control activity. In this case, the fact that they were made by one individual during his first month with Hicks Company suggests that they were a result of his inexperience, not of carelessness.

Because these deviations were the result of intentional actions on the part of Hicks Company‘s employees, Jones should discuss them with the client and its audit committee. Jones should consider why employees committed these actions and their effect on the financial statements. This would certainly increase Jones's assessment of risk of material misstatement.

E.56

Timing of Test of Controls and Sample Selection TO: FROM: DATE: SUBJECT:

Audit Manager Susan Hill October 1 Interim evaluation of control over cash disbursement authorization

I audited 80 cash disbursements as of September 30 for compliance with the company control activity requiring authorization of cash disbursements. I found no deviations. Had this audit sampling been performed at December 31 for the entire year‘s disbursements, I would have been prepared to assign a low control risk (20 percent). This favorable evaluation would enable us to perform the planned analytical procedures to expenses and perform the level of inventory observation work specified in the preliminary audit plan. With a higher control risk, the audit team would need to do more work in both areas. Requirements: According to auditing standards, the audit team needs to determine whether the authorization control activity worked as well during October–December period as it did for the period January–September. I believe that the audit team should audit the other 20 disbursements to make this determination. Options

The audit team cannot elect to forgo all further work on the control for the October–December remaining period.

The audit team can complete the sampling application by examining 20 additional sampling units selected at random. This approach will probably be the least costly because it will be relatively easy to evaluate the additional 20 sampling units to determine whether the control is functioning effectively.

The audit team could make inquiries about the operating effectiveness of the authorization control during the time period from October–December. However, declarations from client personnel that the control ―was functioning just fine‖ would not be good evidence of continued operating effectiveness. Unless this inquiry reveals that the control is no longer performed, inquiry would not provide much information.

The three-month length of the remaining period is long enough for concern. The audit team should not merely presume that the control continued to operate effectively during this period.

If the dollar amount of transactions affected by the operating effectiveness of the authorization control were substantially reduced, the audit team would not need to be as concerned about the control. However, cash disbursements are not likely to become unimportant under these circumstances.

The audit team could forgo examining an additional 20 items and take its chances that the planned amount of analytical procedures for expenses and work on inventory observation would also reveal any control breakdown in October–December. I do not recommend such action in the circumstances because (1) we should evaluate control risk in order to plan the extent of the further audit procedures, (2) the cost of examining an additional 20 items is not high, (3) audit completion might be delayed if we detect a control breakdown later in the audit, and (4) in these circumstances, the dual-purpose nature of the other work may turn out to be circular and inefficient.

I trust I have made clear my preference for completing the test of controls for the authorization control related to cash disbursements. I think this work should be done no earlier than December 20.

E.57

Sample Selection

In this case, the challenge is the fact that the checking accounts have overlapping check numbers. Checks written on Account 2 could be considered as numbers 0001 through 6,000 and checks written on Account 1 could be considered as 6001 through 9000 (simply add 2,368 to each check number). For unrestricted random selection, you could identify random numbers between 1 and 9,000 and select the associated check. For systematic random selection, you would choose a random starting point, calculate the sampling interval, and proceed through the population of checks.

In this case, the challenge is that random numbers 1 through 8,999 would be discarded in an unrestricted random selection method. You could convert the five-digit sequence (9,000–13,999) to a four-digit sequence by subtracting the constant 8,999 from each purchase order number. This would yield purchase orders numbered 0001 through 5,000. If that adjustment were made when using unrestricted random selection, identifying random numbers between 0001 and 5,000 would provide the item selected. If you are concerned about discarding random numbers 5,001 through 9,999, you could create a duplicate set of purchase order numbers by adding the constant 5,000 to each number. As a result, item 1 would have two random numbers: 0001 and 5,001. However, you should be certain not to select the same item using two different random numbers. With respect to systematic random selection, you would choose a random starting point, calculate the sampling interval, and proceed through the population of purchase orders. However, you would not create a duplicate set of purchase orders when you reached the end of the population; you merely would begin applying the sampling interval to the beginning of the population until the appropriate number of items is selected.

In this case, the challenge is the sheer magnitude of the list and the time it would take to select the sample. You can think of this listing as containing a total of 3,750 records [(74 pages x 50 items = 3,700) + 40 items on last page = 3,740 items]. If unrestricted random selection is used, you would identify random numbers corresponding to items 0001 through 3,740. Although this is relatively straightforward, the physical act of moving through the population is quite time consuming. If you are concerned about discarding random numbers 3,741 through 9,999, you could create a duplicate set of inventory line numbers by adding the constant 3,741 to each number. As a result, item 1 would have two random numbers: 0001 and 3,742. However, you should be certain not to select the same item using two different random numbers. If systematic random selection is used, you would choose a random starting point, calculate the sampling interval, and proceed through the perpetual inventory records. Depending upon the sample size, you may be able to bypass entire pages of the perpetual inventory records.

E.58

Sample Selection Based on the document numbers on the receiving reports, a total of 25,327 receiving reports (no. 38121 – no. 12794 = 25,327) were issued during the year. 1.

Using unrestricted random selection, Janice would select 50, 100, or 500 random numbers from a random number table or computer program and match those numbers to items in the population. For ease of selection, a computer program could be requested to generate the appropriate number of random numbers between 12,794 and 38,121.

Using systematic random selection, Janice would select a random starting point (a number less than the sampling interval) and bypass a fixed number of items based on the sampling interval, as follows: Sample size of 50: 25,327  50 items = 506 items (rounded down to be conservative) Sample size of 100: 25,327  100 items = 256 items (rounded down to be conservative) Sample size of 500: 25,327  500 items = 50 items (rounded down to be conservative)

E.59

Sample Selection a.

For McNeal‘s sample of invoices to be representative of the population of sales invoices, the sales invoice should (1) have been prepared throughout the year, (2) represent transactions of larger and smaller dollar amounts, (3) have been prepared by different individuals, and (4) represent sales made to different types of customers and/or customers in different geographic areas.

Because systematic selection bypasses a fixed number of items within the population, it is important that the population be arranged in random order. If it is not, a large number of items possessing similar characteristics may be bypassed for selection.

Because invoices are maintained in hard copy by date, this population cannot easily be rearranged in random order. However, because the invoices are arranged by date, the population is likely to be in random order. Unless the sales made by Branyon differ systematically across dates (for example, all of the large dollar sales are made in one relatively short period of time), this would not introduce any additional issues with respect to the use of systematic selection. However, McNeal must satisfy himself that the invoices in the files represent the complete population of sales.

Because invoices are maintained in hard copy by customer classification, this population cannot be easily rearranged in random order. An additional concern is the fact that the invoices are not arranged in a random order with respect to sales volume. In this situation, if the proportion of high volume customers is relatively small, the use of systematic selection may result in this entire classification being bypassed by McNeal.

This situation is similar to (1) except that McNeal will not have direct access to the sales invoices. This introduces the concern that Branyon‘s personnel will not provide invoices to McNeal that reflect deviations from internal control policies and procedures. McNeal should insist on visiting the off-site location and personally select the invoices for examination.

E.60

Because invoices are maintained electronically, McNeal can arrange the population in whatever order he wishes. Because the electronic file of invoices is currently arranged by customer name (which would ordinarily be random), it appears that McNeal may proceed using systematic selection without considering any further matters. He can satisfy himself that the population is complete by using a CAAT to total the invoices in the file and compare the total to the general ledger balance.

Sample Size Determination a.

Using the sample size tables for a 5 percent risk of overreliance, 3 percent expected population deviation rate, and 9 percent tolerable rate of deviation results in a sample size of 84 items.

Phillips would determine the risk of overreliance judgmentally based on the level of control risk (as the level of control risk is lower, the risk of overreliance should be established at lower levels). The expected population deviation rate is established based on prior audits (for recurring engagements) or a pilot sample of controls (for first-year engagements). The tolerable rate of deviation is established based on the level of control risk (as the level of control risk is lower, the tolerable rate of deviation should be established at lower levels).

E.61

The revised sample size is 58 items.

Because the acceptable risk of overreliance has increased, Phillips‘s sample does not need to be as effective as when acceptable risk of overreliance is lower (the original level of 5 percent). As a result, she can examine a smaller sample.

Sample Size Determination a. b. c. d.

Sample size = 42 Sample size = 129 Sample size = 195 Sample size = 32

Comparison of the appropriate sample sizes in (a) and (b) indicates that the only difference in sample size is related to an increase in the expected population deviation rate from 0 percent in (a) to 3 percent in (b). As a result, the increase in sample size from 42 to 129 indicates that the expected population deviation rate has a direct relationship with sample size. Comparison of the appropriate sample sizes in (b) and (c) indicates that the only difference in sample size is related to a decrease in the tolerable rate of deviation from 7 percent in (b) to 6 percent in (c). As a result, the increase in sample size from 129 to 195 indicates that the tolerable rate of deviation has an inverse relationship with sample size. Comparison of the appropriate sample sizes in (a) and (d) indicates that the only difference in sample size is related to an increase in the risk of overreliance from 5 percent in (a) to 10 percent in (d). As a result, the decrease in sample size from 42 to 32 indicates that the risk of overreliance has an inverse relationship with sample size.

E.62

Sample Size Determination a. b. c. d.

Sample size = 156 Sample size = 192 Sample size = 103 Sample size = 132

Comparison of the appropriate sample sizes in (a) and (b) indicates that the only difference in sample size is related to an increase in the expected population deviation rate from 1 percent in (a) to 1.5 percent in (b). As a result, the increase in sample size from 156 to 192 indicates that the expected population deviation rate has a direct relationship with sample size. Comparison of the appropriate sample sizes in (b) and (c) indicates that the only difference in sample size is related to an increase in the tolerable rate of deviation from 4 percent in (b) to 6 percent in (c). As a result, the decrease in sample size from 192 to 103 indicates that the tolerable rate of deviation has an inverse relationship with sample size. Comparison of the appropriate sample sizes in (b) and (d) indicates that the only difference in sample size is related to an increase in the risk of overreliance from 5 percent in (b) to 10 percent in (d). As a result, the decrease in sample size from 192 to 132 indicates that the risk of overreliance has an inverse relationship with sample size.

E.63

Sample Size Determination a. b. c. d.

E.64

66 9 percent 3.25 percent 5 percent

Sample Size Determination a.

Cambridge should consider the expected population deviation rate, risk of overreliance, and tolerable rate of deviation in determining the necessary sample size. These factors are determined as follows: 

Expected population deviation rate: Determined based on prior audits (for recurring engagements) or a pilot sample of controls (for first-year engagements).



Risk of overreliance: Determined based on the level of control risk.



Tolerable rate of deviation: Determined based on the level of control risk and desired degree of assurance.

Cambridge would determine sample size as follows: (1) select appropriate sample size table based on risk of overreliance, (2) identify the row of the table corresponding to the expected population deviation rate, (3) identify the column of the table corresponding to the assessed tolerable rate of deviation, and (4) determine the sample size by identifying the junction of the row from step 2 and the column from step 3.

Based on an expected population deviation rate of 1 percent, a risk of overreliance of 10 percent, and a tolerable rate of deviation of 6 percent, the appropriate sample size is 64.

Changes in the size of the population do not affect any of the factors used to determine sample size or sample size from the AICPA tables.

Remediation of control deficiencies would reduce the expected population deviation rate, which would result in a smaller sample size.

Turnover of personnel in the purchasing function would increase the expected population deviation rate, which would result in a larger sample size. It might also affect Cambridge‘s assessment of control risk.

The reduction in control risk would influence both the risk of overreliance (decrease) and the tolerable rate of deviation (decrease). Both of these factors would result in a larger sample size.

Increases in control risk would influence both the risk of overreliance (increase) and the tolerable rate of deviation (increase). Both of these factors would result in a smaller sample size.

In most cases, the addition of new vendors should not influence any of the factors affecting sample size or sample size itself. A case could be made that some additional deviations would occur as the vendor list is being modified, which would increase the expected population deviation rate and result in a larger sample size.

If Cambridge increases her reliance on internal control, she will reduce the necessary level of control risk, which will ultimately decrease the acceptable risk of overreliance and tolerable rate of deviation. Both of these factors will result in a larger sample size. Therefore, one impact of increasing the reliance on internal control is that Cambridge will incur additional costs in the form of tests of controls. In addition, the lower tolerable rate of deviation that would be required in this situation increases the likelihood that her tests of controls will not support the planned level of control risk. However, the advantage of Cambridge‘s increasing her reliance on internal control is cost savings in the form of performing less extensive substantive procedures. If Cambridge maintains her reliance on internal control at planned levels, the extent of her tests of controls will not be affected and will be lower than the necessary level if she increases her reliance on internal control. However, she will need to perform more extensive substantive procedures than had she increased reliance on controls.

When deciding whether to increase her reliance on internal control, Cambridge should consider the likelihood that her tests of controls would support an increased level of reliance on internal control as well as the relative cost savings (in the form of less extensive substantive procedures) that this increased reliance on internal control would provide.

E.65

Sample Results Evaluation a.

Sample rate of deviation = Number of deviations  Sample size Sample rate of deviation = 3  60 = 0.05, or 5 percent

Using the sample AICPA evaluation table, the ULRD is 12.5 percent. Allowance for sampling risk = ULRD – Sample rate of deviation Allowance for sampling risk = 12.5 percent – 5 percent = 7.5 percent

E.66

The ULRD considers the likelihood that the sample selected by Plane may under represent the rate of deviation in the population. The ULRD provides a conservative measure of the population rate of deviation to control Plane‘s exposure to sampling risk to acceptable levels.

Because the ULRD (12.5 percent) exceeds the tolerable rate of deviation (6 percent), Plane would conclude that the control is not functioning effectively. At this point, she could either reduce her planned level of reliance on internal control or expand the sample to examine a larger number of controls.

Using the sample evaluation table for a 10 percent risk of overreliance yields a ULRD of 10.8 percent; although lower than the ULRD determined for a 5 percent risk of overreliance (12.5 percent), this ULRD still exceeds the tolerable rate of deviation of 6 percent. As a result, Plane would still conclude that the control is not functioning effectively.

Sample Results Evaluation a.

(1) (2) (3)

Sample rate of deviation = 4  60 = 6.7 percent ULRD = 14.7 percent Allowance for sampling risk = 14.7 percent – 6.7 percent = 8.0 percent

(1) (2) (3)

Sample rate of deviation = 6  60 = 10 percent ULRD = 18.8 percent Allowance for sampling risk = 18.8 percent – 10 percent = 8.8 percent

(1) (2) (3)

Sample rate of deviation = 6  60 = 10 percent ULRD = 16.9 percent Allowance for sampling risk = 16.9 percent – 10 percent = 6.9 percent

The comparison of the ULRDs in (a) and (b) would indicate that the only difference in the ULRD is related to an increase in the number of deviations from 4 in (a) to 6 in (b). As a result, the increase in ULRD from 14.7 percent to 18.8 percent indicates that the number of deviations (and sample rate of deviation) has a direct relationship with the ULRD. The comparison of the ULRDs in (b) and (c) would indicate that the only difference in the ULRD is related to an increase in the risk of overreliance from 5 percent in (b) to 10 percent in (c). As a result, the decrease in the ULRD from 18.8 percent to 16.9 percent indicates that the risk of overreliance has an inverse relationship with the ULRD.

E.67

Sample Results Evaluation a.

(1) (2) (3)

Sample rate of deviation = 8  100 = 8.0 percent ULRD = 14.0 percent Allowance for sampling risk = 14.0 percent – 8.0 percent = 6.0 percent

(1) (2) (3)

Sample rate of deviation = 4  100 = 4.0 percent ULRD = 9.0 percent Allowance for sampling risk = 9.0 percent – 4.0 percent = 5.0 percent

(1) (2) (3)

Sample rate of deviation = 8  100 = 8.0 percent ULRD = 12.7 percent Allowance for sampling risk = 12.7 percent – 8.0 percent = 4.7 percent

The comparison of the ULRDs in (a) and (b) would indicate that the only difference in the ULRD is related to a decrease in the number of deviations from 8 in (a) to 4 in (b). As a result, the decrease in ULRD from 14.0 percent to 9.0 percent indicates that the number of deviations (and sample rate of deviation) has a direct relationship with the ULRD. The comparison of the ULRDs in (a) and (c) would indicate that the only difference in the ULRD is related to an increase in the risk of overreliance from 5 percent in (a) to 10 percent in (c). As a result, the decrease in the ULRD from 14.0 percent to 12.7 percent indicates that the risk of overreliance has an inverse relationship with the ULRD.

E.68

E.69

Sample Results Evaluation a.

Sample rate of deviation = 2  30 = 0.0667, or 6.7 percent

ULRD = 19.6 percent

Allowance for sampling risk = 19.6 percent – 6.7 percent = 12.9 percent

Using four deviations, a risk of overreliance of 5 percent and a ULRD of 12.6 percent yields a sample size of 70.

Sample rate of deviation = 4  70 [see (d) above] = 0.057, or 5.7 percent

Allowance for sampling risk = 12.6 percent – 5.7 percent = 6.9 percent

Number of deviations = 200 x 0.025 = 5

ULRD = 4.6 percent

Sample rate of deviation = 2  50 = 4 percent

[NOTE TO INSTRUCTOR: Students must complete (k) prior to completing (j).] Reviewing the sample evaluation tables for two deviations, a sample size of 50, and a ULRD of 12.1 percent reveals a risk of overreliance of 5 percent.

ULRD = 8.1 percent + 4 percent = 12.1 percent

Sample Results Evaluation

This case is one of Robert Ashton‘s behavioral decision cases (Accounting Review, January 1984, pp. 78–97). He gives credit to W. Uecker and W. Kinney, ―Judgment Evaluation of Sample Results: A Study of the Type and Severity of Errors Made by Practicing CPAs,‖ Accounting, Organizations and Society 2(3), 1977, pp. 269–275. The ―answer‖ is taken from Ashton‘s study (with modifications). NOTE TO INSTRUCTOR: You may want to have the students discuss Cases 1, 2, and 3 first and then give them a chance to think about Cases 4 and 5. See whether they can be fooled into changing their minds to choose the larger samples for Cases 4 and 5, and then discuss them. In this exercise, information about the sample size and sample rate of deviations is available for each pair of outcomes. Although sample size is independent of population parameters, sample rate of deviation is representative of the population characteristic of interest (i.e., the population rate of deviation). Use of the representativeness heuristic could cause one to ignore the size of the sample and to base choices solely on the sample rate of deviation. Thus, one might choose sample A in Case 1 and sample B in Cases 2 and 3 because their sample rate of deviations is lower. The AICPA sample evaluation tables show, however, that none of these three sample outcomes provides adequate assurance that the population rate of deviation is below 5 percent. The other sample outcome (sample B in Case 1 and sample A in Cases 2 and 3) does provide the desired assurance at a 95 percent confidence level (5 percent risk of overreliance). Thus, reliance on the representativeness of the sample outcomes could lead one to choose the weaker evidence in these cases. Notice that the correct choice in Cases 1, 2, and 3 is the larger sample. It might be tempting to conclude that this will always be true (that is, larger samples are always superior to smaller samples). But this simplification will not always work either. Consider Cases 4 and 5. The correct answers are the smaller samples (although neither sample provides the desired assurance in Case 5). Interestingly, use of the representativeness heuristic (i.e., focusing on the lower rate of deviations) would lead to the correct choices in these two instances but would result in incorrect choices in the first three pairs of sample outcomes. This illustrates that although the use of simplifying heuristics can lead to good decisions, it can also lead the decision maker into making sub optimal decisions.

E.70

Sample Results Evaluation a.

Based on a sample size of 90 (rounded down from 93), a risk of overreliance of 5 percent, and zero deviations, the sample rate of deviation is 0 percent (0 ÷ 93 = 0 percent), and the ULRD (using the AICPA sample evaluation tables) is 3.3 percent.

The difference between the sample rate of deviation and ULRD is the allowance for sampling risk. The allowance for sampling risk control is the risk of overreliance to acceptable levels and reflects the possibility that Jackson has selected a nonrepresentative sample.

Because the ULRD (3.3 percent) is less than the tolerable rate of deviation (5 percent), Jackson would conclude that Town Mo‘s control is operating effectively and choose to rely on the internal control as planned.

If three deviations were identified, the sample rate of deviation is 3.2 percent (3 ÷ 93 = 3.2 percent), and the ULRD (using the AICPA sampling tables) is 8.4 percent. Because the ULRD of 8.4 percent exceeds the tolerable rate of deviation of 5 percent, Jackson would conclude that the control is not operating effectively and choose to reduce reliance on the internal control from planned levels. For a risk of overreliance of 5 percent and a sample size of 90, the ULRD is 3.3 percent if zero deviations are found and 5.2 percent if one deviation is found. As a result, the maximum number of deviations that Jackson could permit without reducing his reliance on internal control is zero because the ULRD for one deviation (5.2 percent) exceeds the tolerable rate of deviation.

For a risk of overreliance of 10 percent and a sample size of 90, the ULRD is 2.6 percent if zero deviations are found, 4.3 percent if one deviation is found, and 5.9 percent if two deviations are found. As a result, the

maximum number of deviations that Jackson could permit without reducing his reliance on internal control is one because the ULRD for two deviations (5.9 percent) exceeds the tolerable rate of deviation. This analysis reveals lower ULRDs compared to those for a 5 percent risk of overreliance. This difference results from the fact that Jackson is accepting a higher level of sampling risk, which reduces the allowance for sampling risk. Simply stated, a lower risk of overreliance provides Jackson a more conservative (higher) ULRD.

E.71

Evaluating a Sampling Application

Mistake

Explanation

The statistical criteria call for a sample of 181, not 100.

Barton apparently did not use AICPA sampling tables in determining sample size or misread them.

Barton used two test months for his selection of sample items.

A selection of two months does not make the sample representative of the year‘s population; checks should be examined for selections from months throughout the year.

Barton did not define the deviation conditions carefully before beginning his sampling application.

Barton subsequently decided that the two deviations he found were not control deviations.

Barton did not follow up sufficiently on the deviations he found.

The pay rate mistake has a dollar value impact that Barton did not recognize (i.e., liability for underpayment of wages).

Barton improperly combined a stratified sample into a single evaluation.

When stratification is done properly, the two samples should be evaluated independently.

The reviewers (senior and partner) were not competent to review the statistical application.

This is not Barton‘s mistake, but it is worthwhile to point out that competence is as necessary at the review level as it is at the performance level.

E.72

Comprehensive Attributes Sampling a.

Dodge would have determined the risk of overreliance judgmentally based on the level of control risk (as the level of control risk is lower, the risk of overreliance should be established at lower levels). The expected population deviation rate is established by Dodge based on prior audits (for recurring engagements) or a pilot sample of controls (for first-year engagements). The tolerable rate of deviation is established by Dodge based on the level of control risk (because the level of control risk is lower, the tolerable rate of deviation should be established at lower levels) and the desired degree of assurance.

If Dodge wishes to place additional reliance on this control, she would reduce the risk of overreliance and the tolerable rate of deviation. Dodge‘s decision to place additional reliance on the control would not influence the level of the expected population deviation rate.

Using the AICPA sample size tables determines that the appropriate sample size corresponding to a risk of overreliance is 5 percent, an expected population deviation rate is 1.5 percent, and a tolerable rate of deviation of 4 percent is 192 items.

Sample rate of deviation = Number of deviations  Sample size Sample rate of deviation = 4  192 = 0.021, or 2.1 percent (rounded)

Using a 5 percent risk of overreliance, 4 deviations, and a sample size of 200 (the next highest sample size on the table), the ULRD is 4.6 percent.

Because the ULRD (4.6 percent) is greater than the tolerable rate of deviation (4.0 percent), Dodge would not be able to conclude that the control is functioning effectively. She would either reduce her reliance on internal control (increase the assessed level of control risk) or select additional items and reevaluate the results of her tests of controls.

E.73

Nonstatistical Attributes Sampling a.

She would define a deviation as a situation in which the receiving reports do not have an indication that they have been verified by Rock‘s receiving personnel (this indication is in the form of marks adjacent to the quantities verified and a signature on the receiving report).

Aubrey would define the population as all receiving reports prepared during the year (or period) under audit. The completeness of the population would be verified by identifying the document numbers corresponding to the first and last receiving reports prepared by Rock‘s personnel during the year (or period) under audit. The list should also be reviewed for any gaps or overlaps in numeric sequence.

Rock‘s computerized list can be used to select items for examination using the following selection methods: 1.

Unrestricted random selection: Aubrey could use computer programs to identify 100 random numbers that correspond to receiving reports and select the related reports.

Systematic random selection: Aubrey could use computer programs to randomly select a starting point in the population and select every n th (corresponding to the sampling interval) receiving report in the population.

Haphazard selection: Aubrey could nonsystematically select receiving reports from the computerized list without any rationale for including or excluding various receiving reports.

Block selection: Aubrey could use computer programs to reorganize the computerized list to select receiving reports prepared by certain individuals, for certain types of vendors, or during certain dates.

The primary precaution that Aubrey should take is to be sure that the computerized listing is randomly arranged, particularly if systematic random selection is used. d.

Sample rate of deviation = 2  100 = 2.0 percent Because the sample rate of deviation is lower than the tolerable rate of deviation (7 percent), Aubrey might rely on the internal control as planned.

Sample rate of deviation = 4  100 = 4.0 percent Because the sample rate of deviation is less than the tolerable rate of deviation (7 percent), Aubrey could not rely on the internal control as planned. However, because the sample rate of deviation is higher than the expected population deviation rate (2.75 percent), she might decide to increase her sample size.

Sample rate of deviation = 10  100 = 10.0 percent Because the sample rate of deviation exceeds the tolerable rate of deviation (7 percent), Aubrey could not rely on the internal control as planned and would need to reduce her reliance on internal control or expand her sample to examine additional items.

E.74

E.75

Nonstatistical Attributes Sampling a.

Nonstatiscal sampling differs from statistical sampling in that it does not allow measurement of sampling risk. Therefore, samples may be selected using nonrandom techniques such as haphazard or block selection.

Because nonrandom techniques can be used, nonstatistical sampling is often faster and easier to perform.

Curtis can select her sample by any method because she is not using statistical sampling. Thus, she can select a block of invoices, or she can choose 50 invoices haphazardly. She can also use random or systematic selection. She must, however, be careful to try to obtain a representative sample.

Because Curtis's expected population deviation rate is zero and her sample rate of deviation is 2 percent (1  50), Curtis must either expand her sample size or increase control risk. Increasing control risk will lead to decreased detection risk and expanded substantive procedures.

Comprehensive Attributes Sampling a.

Based on the parameters identified in the prior audit, it appears that a sample size of 55 invoices was appropriate. In addition, the calculation of the ULRD and decision to reduce reliance on the control activity was also appropriate.

In the prior-year audit, your firm was unable to conclude that the control was operating effectively with a 10 percent risk of overreliance. Given this finding, as well as the fact that you did not observe any major changes or remediation with respect to these controls in the current year, it seems unlikely that an increased reliance on the control activity is viable.

To increase the reliance on this control activity in the current audit, you will need to reduce both the risk of overreliance and the tolerable rate of deviation. The result of these actions will be the need for a larger sample size.

Using a risk of overreliance of 5 percent, a tolerable rate of deviation of 6 percent, and an expected population deviation rate of 1 percent, the sample size in the current audit is 78 items. As anticipated, this is a larger sample size than that used in the prior-year audit (55 items).

Although it is impossible to determine the exact increase resulting from changes in these individual factors, the sample size for the prior-year audit and changes in the parameters in the current audit are as follows (ROO = risk of overreliance, EPDR = expected population deviation rate, TRD = tolerable rate of deviation): (1) ROO = 10 percent, EPDR = 1 percent, TRD = 7 percent: (2) ROO = 5 percent, EPDR = 1 percent, TRD = 7 percent: (3) ROO = 10 percent, EPDR = 1 percent, TRD = 6 percent:

55 items 66 items 64 items

The parameters in set (1) represents those used in last year‘s audit. Note that reducing the risk of overreliance from 10 percent to 5 percent [set (2)] results in an increase in the sample size of 11 items (66 items – 55 items = 11 items). Reducing the tolerable rate of deviation from 7 percent to 6 percent [comparing sets (1) and (3)] results in an increase in the sample size of 9 items (64 items – 55 items = 9 items). As a result, changes in both factors do independently result in an increase in the sample size. You should note that the final sample size for the current set of parameters [noted in (d)] is 78 items. This sample size is larger than the sample size obtained by adding the individual effect(s) of decreasing the risk of overreliance and decreasing the tolerable rate of deviation, indicating that the interactive effects of these changes are larger than the individual effects. 1-511 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

E.76

E.77

Based on a sample size of 100 items and a risk of overreliance of 5 percent, the ULRD for zero deviations is 3 percent, the ULRD for one deviation is 4.7 percent, and the ULRD for two deviations is 6.2 percent. Because the tolerable rate of deviation is 6 percent, you would need to find one or fewer deviations to rely on the control activity at the planned level. Given the rate of deviations noted in last year‘s audit, as well as the lack of changes in internal control or remediation with respect to these controls during the current year, increasing your reliance on internal control does not appear to be feasible.

Based on a sample size of 100 items and a risk of overreliance of 10 percent, the ULRD for zero deviations is 2.3 percent, the ULRD for one deviation is 3.9 percent, the ULRD for two deviations is 5.3 percent, and the ULRD for three deviations is 6.6 percent. For a tolerable rate of deviation of 6 percent, you could allow up to two deviations and choose to rely on the control at the planned level.

The ULRD is inversely related to the risk of overreliance; that is, as the risk of overreliance decreases, the ULRD increases (and vice versa). From a practical standpoint, this means that, for higher levels of the risk of overreliance, the audit team can observe a higher number of deviations and still rely on internal control at the planned level.

General Attributes Sampling a.

This statement is not correct. Generally accepted auditing standards permit the use of either statistical sampling or nonstatistical sampling.

This statement is not correct. Control risk should be determined prior to the determination of detection risk. In fact, the level of detection risk will depend on the assessed level of control risk.

This statement is correct. The risk of overreliance relates to the effectiveness of an audit. If control risk is assessed at inappropriately low levels, the extent of further audit procedures will not be sufficient to control audit risk to acceptable levels.

This statement is not correct. Although segregation of duties is an important control, sampling is generally not appropriate for controls that do not provide documentary evidence (such as segregation of duties).

This statement is correct. As the degree of assurance required by a control increases, the necessary tolerable rate of deviation decreases.

This statement is not correct. He needs to consider the sampling risk that may be present in this situation.

This statement is not correct. Although all deviations do have the same effect on the ULRD, it is important to consider qualitative aspects of deviations, such as (1) whether deviations are intentional or unintentional and (2) the possible relationship of the deviation to other phases of the audit.

This statement is not correct. Even when the ULRD is lower than the tolerable rate of deviation, audit teams must be careful to follow up on all deviations to understand their cause.

Comprehensive Nonstatistical Attributes Sampling 

Document your reasoning for choosing to use nonstatistical sampling. If you believe the reduction in hours can be accomplished because nonstatistical sampling is generally simpler, that is acceptable. However, if the reasoning is that nonstatistical sampling requires smaller sample sizes, that is not acceptable under auditing standards.



Document the reason for reducing the sample size from last year. Can you justify increasing risk, tolerable deviation rate, or expected deviation rate? If not, the sample size should have been comparable.



Document how you ensured that controls were operating effectively for the first 11 months of the year.



By selecting every 10th invoice until you reached 100, you are assuming there were 1,000 invoices written in December. What was the actual number?



The missing invoice should have been counted as a deviation.



You need to follow up on the reasons for the two invoices that differ in amount from the shipping document.

E.78

Discovery and Sequential Attributes Sampling a.

This is not a good situation to use discovery sampling. The high risk of overreliance and high tolerable rate of deviation along with the 2 percent expected rate of deviation suggest that the area is not extremely important to the extent that there should be no deviations.

In using discovery sampling, the audit team could go to the AICPA tables and determine a sample size for an expected population deviation rate of 0 percent and a very low tolerable deviation rate. For example, the team might use the 5 percent risk of overreliance table to obtain a sample size of 149. If one deviation was discovered, the audit team would stop the test of controls and increase control risk and substantive testing.

Sequential sampling is a sampling plan in which an initial sample is selected and the audit team (1) draws a final conclusion regarding the effectiveness of the control or (2) selects additional items before drawing a final conclusion regarding the effectiveness of the control. It is sometimes called stop-or-go sampling because the plan allows the audit team to stop after examining a relatively small sample and evaluate the results. If the results are clearly acceptable or clearly unacceptable, the audit team can draw its conclusion; if the results are inconclusive, the audit team can go forward and examine additional items.

It is not clear whether sequential sampling should be used on the audit of Jennifer‘s. Last year‘s required sample size under a fixed sampling plan was only 38, so it is unlikely that a sequential sampling plan would result in a much smaller sample. In addition, there is a risk under sequential sampling that the sample would have to be extended if deviations were noted to the point that the total sample size would actually be higher than 34.

Siebenthaler would obtain an appropriate sampling table or use a computer program to determine an initial sample size. If few deviations are found, she might be able to stop testing, or if the deviations exceeded the limit prescribed by the software or the table, she would also stop testing and increase control risk. If, however, the number of deviations led to an indeterminate conclusion, the sample size would have to be expanded before a decision could be made.

SOLUTIONS FOR IDEA EXERCISES AND PROBLEMS (E.79 – E.81) NOTE TO INSTRUCTOR: Videos illustrating how to load data into IDEA and the steps in using IDEA for this exercise are available on the Connect site. Prior to beginning Exercises E.79 – E.81, the data are loaded into IDEA as follows: 1.

Create a managed project in IDEA

Download the ―Module E ELM Required data and documents‖ zip file and extract the contents. This will contain the Sales 2020 – 4th Q database.

Copy the required data into the project file within Documents->My IDEA Projects-> Project name (ELM Company Module E in this example).

Refresh the file list in IDEA to show the databases within your project:

E.79

Attributes Sampling with IDEA: Determining Sample Size, Selecting Sample Items, and Evaluating Sample Results a.

Using the Analysis>Attribute>Planning (Beta Risk Control) function and inputting the Population size of 388, % Expected deviation rate of 1%, % Tolerable deviation rate of 6%, and Confidence level of 90%, IDEA determines an appropriate sample size of 58 items. The audit team could observe up to one deviation without reducing their reliance on the authorization control.

Using the Analysis>Other>Systematic>Number of Records function and inputting the Number of records to select of 58, Starting record number to select of 23, and Ending record number to select of 388, the first five order numbers selected would be 17022, 17028, 17034, 17040, and 17046. The first item is the 23rd item in the population (corresponding to the random start) and every sixth item thereafter is selected, which is the sampling interval (388 items in population ÷ 58 items in sample = 6.7). (NOTE TO INSTRUCTOR: In this example, the client has issued two duplicate orders 17015, which explains why order 17022 is the 23rd item in the population).

Using the Analysis>Attribute>Sample Evaluation function and inputting the Population size of 388, Sample size of 58, Number of deviations in sample of 3, and % Desired confidence level of 90%, IDEA provides a ULRD of 10.57 percent. Since this exceeds the tolerable rate of deviation (6 percent), the audit team would conclude that the authorization control is not functioning effectively and reduce their reliance on this control.

E.80

Attributes Sampling with IDEA: Determining Sample Size For parts (a) – (d), use the Analysis>Attribute>Planning (Beta Risk Control) function and input the appropriate parameters for Population size, % Expected deviation rate, % Tolerable deviation rate, and Confidence level to determine the appropriate sample size. (The screen shot for the parameters in part (a) is shown below.)

The appropriate sample size is 58 items.

Using a risk of overreliance of 5 percent, an expected population deviation rate of 1 percent, and a tolerable rate of deviation of 6 percent, the appropriate sample size is 70 items.

Using a risk of overreliance of 10 percent, an expected population deviation rate of 2 percent, and a tolerable rate of deviation of 6 percent he appropriate sample size is 79 items.

Using a risk of overreliance of 10 percent, an expected population deviation rate of 1 percent, and a tolerable rate of deviation of 8 percent, the appropriate sample size is 44 items.

Comparing the results in parts (b), (c), and (d) to part (a), the following relationships can be observed: 

As the risk of overreliance decreases from 10 percent to 5 percent, the sample size increases from 58 items to 70 items (the risk of overreliance has an inverse relationship with sample size).



As the expected population deviation rate increases from 1 percent to 2 percent, the sample size increases from 58 items to 79 items (the expected population deviation rate has a direct relationship with sample size).



As the tolerable rate of deviation increases from 6 percent to 8 percent, the sample size decreases from 58 items to 44 items (the tolerable rate of deviation has an inverse relationship with sample size).

E.81

Attributes Sampling with IDEA: Evaluating Sample Results For parts (a) – (b), use the Analysis>Attribute>Sample Evaluation function and input the appropriate he Population size of 388, Sample size of 58, Number of deviations in sample (varies), and % Desired confidence level of 90% to determine the appropriate ULRD. (The screen shot for 3 deviations is shown below.)

The ULRD is 10.57 percent. Since this exceeds the tolerable rate of deviation (6 percent), the audit team would conclude that the authorization control is not functioning effectively and reduce their reliance on this control.

If 0 deviations are observed, the ULRD is 3.35 percent. Since this is less than the tolerable rate of deviation (6 percent), the audit team would conclude that the authorization control is functioning effectively and rely on this control as planned.

If 1 deviation is observed, the ULRD is 5.93 percent. Since this is less than the tolerable rate of deviation (6 percent), the audit team would conclude that the authorization control is functioning effectively and rely on this control as planned (although since the ULRD approaches the tolerable rate of deviation, the audit team may wish to expand their sample).

If 2 deviations are observed, the ULRD is 8.51 percent. Since this is greater than the tolerable rate of deviation (6 percent), the audit team would conclude that the authorization control is not functioning effectively and reduce their reliance on this control.

As the number of deviations increases, the ULRD increases, reducing the likelihood that the audit team would rely on the control as planned.

MODULE F Variables Sampling LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises and Problems

Define variables sampling and understand when it is used in the audit.

1, 2

23, 24, 25, 36

58 (*), FB.14 (*)

Understand the basic process underlying monetary unit sampling (MUS) as well as when to use MUS.

3, 4, 5, 6

27, 28, 30, 31

61 (*), FB.21 (*)

Identify the factors affecting the size of an MUS sample and calculate the sample size for an MUS application.

7, 8, 9, 10, 11, 12, 13, 14, 15, 16

29, 32, 37, 41

44, 45, 46, 47, 48, 49, 50, 51, 58 (*), 59 (*), 60 (*), 61 (*), 63, 64, 66 (*)

Evaluate the results for an MUS sample by calculating the projected misstatement, incremental allowance for sampling risk, and basic allowance for sampling risk.

17, 18, 19, 20, 21, 22

26, 33, 34, 35, 38, 39, 40, 42, 43

52, 53, 54, 55, 56, 57, 58 (*), 59 (*), 60 (*), 61 (*), 62, 65, 66 (*)

Understand the basic process underlying classical variables

FB.1, FB.2, FB.3, FB.4, FB.5, FB.6,

FB.11, FB.12, FB.13

FB.14 (*), FB.15, FB.16, FB.17, FB.18,

sampling as well as the use of classical variables sampling in an audit (Appendix FB)

FB.7, FB.8, FB.9, FB.10

FB.19, FB.20, FB.21 (*)

Understand the use of nonstatistical approaches to variables sampling (Appendix FC).

FC.1, FC.2

FC.3, FC.4

(*) indicates that an item corresponds to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS F.1

Variables sampling is a form of audit sampling used to examine a population to estimate the amount (or value) of some characteristic of that population. Variables sampling is used when the audit team performs substantive procedures.

F.2

The two approaches available for variables sampling are monetary unit sampling (MUS) and classical variables sampling.

F.3

Monetary unit sampling (MUS) is a variables sampling method in which the population is viewed as being composed of individual dollars (or euros, yuan, yen) within an account balance or class of transactions. The unique feature of MUS is its definition of the population as the number of dollars in an account balance or class of transactions. Viewed another way, in MUS, individual dollars within an account balance or class of transactions are identified as sampling units.

F.4

The advantages of MUS are that it (a) results in relatively small sample sizes, (b) has samples that typically include transactions or components reflecting relatively large dollar amounts, (c) is more effective in identifying misstatements in accounts when overstatement is the primary concern, and (d) is generally simpler to use than classical variables sampling. The disadvantages of MUS are that it (a) provides a conservative (higher) estimate of misstatement in the account balance or class of transactions, (b) is not effective in identifying misstatements in accounts when understatement is the primary concern, (c) has difficulty expanding its sample when preliminary results suggest that an account balance or class of transactions is materially misstated, and (d) requires special considerations for logical units having a zero or negative balance. MUS is best used when audit teams expect to find few or no misstatements and when overstatement is the greatest concern.

F.5

The objective of MUS is to provide evidence regarding the fairness of financial statement assertions, which determine the type of substantive procedures used by the audit team.

F.6

The characteristic of interest in an MUS application is the amount at which the items should be recorded if no mistakes in the application of generally accepted accounting principles are noted (referred to as the audited value).

F.7

The two sampling risks associated with variables sampling are the risk of incorrect acceptance and the risk of incorrect rejection. The risk of incorrect acceptance is the likelihood that the sample results will indicate that the account balance is fairly stated when, in fact, it is materially misstated. The risk of incorrect rejection is the likelihood that the sample results will indicate that the account balance is materially misstated when, in fact, it is fairly stated. The risk of incorrect acceptance exposes the audit team to an effectiveness loss because the audit team will make an incorrect conclusion and issue an inappropriate opinion on financial statements that are materially misstated. The risk of incorrect rejection exposes the audit team to an efficiency loss because it will examine additional transactions or components prior to proposing an adjustment to the financial statements.

F.8

The audit team determines the acceptable level of the risk of incorrect acceptance by solving the audit risk model for test of details risk based on prior assessments of audit risk, risk of material misstatement, and analytical procedures risk. The risk of incorrect acceptance has an inverse relationship with sample size; that is, as the acceptable level of the risk of incorrect acceptance decreases, sample size increases.

F.9

The audit team determines the tolerable misstatement based on the recorded balance of the account balance or class of transactions as well as key financial statement subtotals, such as sales, net income, and total assets. Tolerable misstatement has an inverse relationship with sample size; that is, as the acceptable level of tolerable misstatement decreases, sample size increases.

F.10

The audit team determines expected misstatement is determined based on prior audits (for recurring engagements) or a pilot sample (for first-year engagements). Expected misstatement has a direct relationship with sample size; that is, as the expected misstatement increases, sample size increases.

F.11

In an MUS application, the audit team bases the population size on the recorded balance of the account balance. The population size has a direct relationship with sample size; that is, as the population size increases, sample size increases.

F.12

In selecting an MUS sample, the audit team begins by determining a random starting point within the population. The team then bypasses a fixed number of items in the population and selects the next item for examination; the number of items bypassed is based on the sampling interval. This process is then continued until a number of sampling units equal to the appropriate sample size are selected. When a sampling unit (dollar of an account balance or class of transactions) is selected, the audit team examines the entire logical unit containing that dollar. Because larger components and transactions contain a higher number of sampling units (dollars), MUS has a tendency to select larger components or transactions for examination.

F.13

The sampling interval represents the frequency with which sampling units are selected and is determined by dividing the recorded balance of the population (account balance) by the sample size. The sampling interval represents the number of logical units that are bypassed between selections.

F.14

If one logical unit contains two separate dollar selections, that logical unit will account for two selections.

F.15

The audited value is the amount at which a component or transaction should be recorded, assuming no departures from generally accepted accounting principles.

F.16

The tainting percentage is an amount that represents the proportion by which a logical unit is misstated; it is determined by dividing the amount of the misstatement by the recorded balance.

F.17

The three components of the upper limit on misstatements are the projected misstatement, the incremental allowance for sampling risk, and the basic allowance for sampling risk. The projected misstatement is determined by multiplying the sampling interval by the tainting percentage for the misstatement found in that sampling interval. The incremental allowance for sampling risk is determined as follows: a.

For all projected misstatements less than the sampling interval, rank the projected misstatements in descending order based on the dollar amount.

For each misstatement in (a), determine the incremental confidence factor associated with the discovery of the misstatement.

For each misstatement in (a), multiply the (incremental confidence factor minus 1.00) by the projected misstatement.

The basic allowance for sampling risk is determined by multiplying the sampling interval by the confidence factor for the acceptable risk of incorrect acceptance (assuming zero overstatement errors). F.18

These misstatements are not projected because the recorded balance is higher than the sampling interval over which the misstatement is to be projected.

F.19

The upper limit on misstatements is the amount that has a (1 – Risk of incorrect acceptance) probability of equaling or exceeding the true amount of misstatement in the population; that is, it is the sum of the projected misstatement, incremental allowance for sampling risk, and basic allowance for sampling risk. The upper limit on misstatements provides the audit team the amount that has a (1 minus risk of incorrect acceptance) probability of equaling or exceeding the true amount of misstatement in the population.

F.20

F.21

If the upper limit on misstatements exceeds the tolerable misstatement, the audit team could: a.

Increase the sample size and examine additional items. If no more errors are found, these additional items would effectively reduce the sampling interval used by the audit team and, as a result, reduce the upper limit on misstatements.

Recommend adjustment to the recorded balance of the client‘s account balance or class of transactions.

Classical variables sampling is an approach that uses the laws of probability and the central limit theorem to provide an estimate of either the amount of misstatement or the true balance of an account balance or class of transactions. Nonstatistical sampling is a variables sampling approach that does not measure and control the audit team‘s exposure to sampling risk in determining sample size or evaluating sample results. Both classical variables sampling and nonstatistical sampling are permissible under generally accepted auditing standards.

F.22

Information that is typically documented during variables sampling includes: 

The objective of sampling, definition of the characteristic of interest, and definition of the population from which the sample was selected.



The parameters used to determine sample size, which might include sampling risks, tolerable misstatement, expected misstatement, standard deviation of mean values, population size, and assessment of risk of material misstatement and the risk that other substantive procedures will fail to detect a misstatement. In addition to the levels of these factors, the audit team should also document the rationale for these assessments.



The sample size determination based on the preceding factors.



Information on the selection of sample items and a list of items selected and examined by the audit team.



Results of the substantive procedures performed on each item selected (step 6) and the determination of the upper limit on misstatements (MUS), precision interval (classical variables sampling), or estimated audited value (nonstatistical sampling).



The audit team‘s conclusion with respect to the fairness of the account balance and effect of this conclusion on the opinion on the financial statements.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS F.23

F.24

F.25

F.26

F.27

Incorrect

c. d.

Correct Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

Incorrect

Correct

Incorrect

Correct

Incorrect

While preliminary levels of materiality are considered in the variables sampling process, variables sampling is more closely related to the audit team‘s substantive procedures. Attributes sampling (not variables sampling) is most closely related to tests of control procedures. Variables sampling involves the audit team in performing substantive procedures. Searching for the possible occurrence of subsequent events is not an application of sampling. This does not consider dollar size when selecting sample items. This does not consider dollar size when selecting sample items. Under monetary unit sampling, higher dollar items are more likely to be selected for examination. This does not consider dollar size when selecting sample items. Variables sampling methods can be used to estimate both the amount of the misstatement and the true account balance. Variables sampling methods can be used to estimate the true account balance. Variables sampling methods can be used to estimate the amount of the misstatement. Variables sampling methods can be used to estimate both the amount of the misstatement and the true account balance. The upper limit on misstatements should be compared to the tolerable misstatement, not the expected misstatement. The upper limit on misstatements should be compared to the tolerable misstatement, not the incremental allowance for sampling risk. The upper limit on misstatements should be compared to the tolerable misstatement, not the projected misstatement. The upper limit on misstatements should be compared to the tolerable misstatement. While the risk of incorrect rejection does impact the efficiency of the audit, the audit team is not as concerned about the audit‘s efficiency compared to its effectiveness If incorrect acceptance is committed, the audit team will not perform additional substantive procedures and not ultimately reach the correct conclusion. If incorrect acceptance is committed, an inappropriate opinion is issued on materially misstated financial statements, which relates to the audit‘s effectiveness. The risk of incorrect acceptance is not related to the sufficiency or appropriateness of evidence.

F.28

F.29

F.30

F.31

F.32

a. b.

Incorrect Incorrect

Incorrect

Correct

Sampling units are chosen at random under monetary unit sampling. While the dollar units are not replaced before completing the sample selection, this is not a feature unique to monetary unit sampling. Auditors are concerned with and do control their exposure to the risk of incorrect acceptance under monetary unit sampling. Monetary unit sampling uniquely defines sampling units as the number of dollar units in an account balance or class of transactions.

NOTE TO INSTRUCTOR: Because this question asks students to identify the factor that is not considered in calculating a monetary unit sampling (MUS) sample size, the response labeled ―correct‖ is not considered in determining sample size under MUS and those labeled ―incorrect‖ are considered in determining a sample size under MUS. a.

Incorrect

b. c. d.

Incorrect Incorrect Correct

Correct

b. c.

Incorrect Incorrect

Incorrect

Correct

c. d.

Incorrect Incorrect

Audit risk is considered in determining the necessary level of the risk of incorrect acceptance; the risk of incorrect acceptance is, in turn, considered in determining sample size. The tolerable misstatement is considered in determining sample size. The estimated error is considered in determining sample size. The standard deviation of error is considered in classical variables sampling but not in monetary unit sampling. The audit team must consider the risk of incorrect acceptance in determining sample size in monetary unit sampling. Larger logical units (not smaller logical units) have a higher probability of selection. While each sampling unit has an equal likelihood of selection, larger logical units have a higher probability of selection. The projected misstatement can be calculated when misstatements are discovered. Monetary unit sampling is more effective in identifying overstatement (not understatement) errors. Because monetary unit sampling identifies a sampling unit as a dollar of an account balance, it automatically selects high dollar items for examination. Monetary unit sampling does not tend to select small dollar components for examination. A disadvantage of monetary unit sampling is that it is difficult to expand the sample once it has been selected.

NOTE TO INSTRUCTOR: Because this question asks students to identify the situation that would not result in selecting a larger sample, the response labeled ―correct‖ does not result in a larger sample and those labeled ―incorrect‖ result in a larger sample. a. b.

Incorrect Correct

c. d.

Incorrect Incorrect

Reducing the risk of incorrect acceptance would result in an increase in sample size. Increasing the tolerable misstatement would result in a decrease (not increase) in sample size. Increasing the expected misstatement would result in an increase in sample size. Because the increase in tolerable misstatement (b) would result in a decrease in sample size, this response is not correct.

F.33

F.34

F.35

F.36

Incorrect

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

b. c. d.

Because the logical unit (component) selected for examination is larger than the sampling interval ($1,500), the projected misstatement would equal the actual misstatement, or $2,000 ($5,000 – $3,000 = $2,000). Because the logical unit (component) selected for examination is larger than the sampling interval ($1,500), the projected misstatement would equal the actual misstatement, or $2,000 ($5,000 – $3,000 = $2,000). Because the logical unit (component) selected for examination is larger than the sampling interval ($1,500), the projected misstatement would equal the actual misstatement, or $2,000 ($5,000 – $3,000 = $2,000). Because the logical unit (component) selected for examination is larger than the sampling interval ($1,500), the projected misstatement would equal the actual misstatement, or $2,000 ($5,000 – $3,000 = $2,000). The audit team would compare the upper limit on misstatements (not the projected misstatement) to the tolerable misstatement. The audit team would compare the upper limit on misstatements (not the projected misstatement) to the tolerable misstatement. If the upper limit on misstatements is less than the tolerable misstatement, the audit team would conclude that the account balance is fairly stated. The audit team would conclude that the account balance is fairly stated when the tolerable misstatement is more than (not less than) the upper limit on misstatements. If the tolerable misstatement is $15,000 and the upper limit on misstatements is $17,800, a $2,800 adjustment to the financial statements ($17,800 – $15,000 = $2,800) would allow the audit team to conclude that the financial statements are not materially misstated. If the tolerable misstatement is $15,000 and the upper limit on misstatements is $17,800, a $2,800 adjustment to the financial statements ($17,800 – $15,000 = $2,800) would allow the audit team to conclude that the financial statements are not materially misstated. If the tolerable misstatement is $15,000 and the upper limit on misstatements is $17,800, a $2,800 adjustment to the financial statements ($17,800 – $15,000 = $2,800) would allow the audit team to conclude that the financial statements are not materially misstated. If the tolerable misstatement is $15,000 and the upper limit on misstatements is $17,800, a $2,800 adjustment to the financial statements ($17,800 – $15,000 = $2,800) would allow the audit team to conclude that the financial statements are not materially misstated.

While variables sampling will affect the desired level of audit risk, it is associated with performing substantive tests of details. Incorrect Variables sampling is not associated with inherent risk assessments. Incorrect Attributes sampling (rather than variables sampling) is more closely associated with assessing control risk. Correct Variables sampling is associated with performing substantive tests of details.

F.37

a. b.

c. d.

F.38

F.39

F.40

Incorrect

Tolerable misstatement has an inverse (rather than direct) relationship with sample size. Incorrect Tolerable misstatement has an inverse (rather than direct) relationship with sample size and population size has a direct (rather than inverse) relationship with sample size. Correct Tolerable misstatement has an inverse relationship with sample size and population size has a direct relationship with sample size. Incorrect Population size has a direct (rather than inverse) relationship with sample size.

NOTE TO INSTRUCTOR: Because this question asks students to identify which component is not used in determining the upper limit on misstatements, the response labeled ―correct‖ is not used in determining the upper limit on misstatements and those labeled ―incorrect‖ are used in determining it. a.

Incorrect

Correct

Incorrect

c. d.

Incorrect Correct

Incorrect

Correct

Incorrect

The upper limit on misstatements is determined by adding the basic allowance for sampling risk, incremental allowance for sampling risk, and projected misstatement; therefore, the basic allowance for sampling risk is considered. The upper limit on misstatements is determined by adding the basic allowance for sampling risk, incremental allowance for sampling risk, and projected misstatement; therefore, the incremental allowance for sampling risk is considered. The upper limit on misstatements is determined by adding the basic allowance for sampling risk, incremental allowance for sampling risk, and projected misstatement; therefore, the projected misstatement is considered. The upper limit on misstatements is compared to the tolerable misstatement in making the decision as to the fairness of the account balance; however, the tolerable misstatement is not considered in determining the upper limit on misstatements. The risk of incorrect acceptance is used to determine the sample size but not the projected misstatement. The incremental confidence factor is used to determine the incremental allowance for sampling risk. The confidence factor is used to determine the basic allowance for sampling risk. The projected misstatement is determined by multiplying the sampling interval by the tainting percentage. Prior to multiplying the sampling interval by the tainting percentage, the audit team must determine the misstatement by comparing the audited value of the item to the recorded balance. Comparing the audited value to the recorded balance is the first step in determining the upper limit on misstatements. Prior to calculating the basic allowance for sampling risk, the audit team must determine the misstatement by comparing the audited value of the item to the recorded balance. Prior to calculating the incremental allowance for sampling risk, the audit team must determine the misstatement by comparing the audited value of the item to the recorded balance.

F.41

F.42

F.43

Incorrect

Correct

Incorrect

The projected misstatement would be calculated as follows: [($10,000 – $8,000) ÷ $10,000] x $20,000 = $4,000. The projected misstatement would be calculated as follows: [($10,000 – $8,000) ÷ $10,000] x $20,000 = $4,000. The projected misstatement would be calculated as follows: [($10,000 – $8,000) ÷ $10,000] x $20,000 = $4,000. The projected misstatement would be calculated as follows: [($10,000 – $8,000) ÷ $10,000] x $20,000 = $4,000.

NOTE TO INSTRUCTOR: Because this question asks students to identify which statement is not true, the response labeled ―correct‖ is not true and those labeled ―incorrect‖ are true. a.

Incorrect

Correct

Incorrect

The tainting percentage is based on the difference between the recorded balance and the audited value. Incremental allowance for sampling risk is calculated separately for each misstatement identified by the auditor. The basic allowance for sampling risk will always exist even in situations in which no misstatements are detected. The projected misstatement is determined by multiplying the sampling interval by the tainting percentage.

NOTE TO INSTRUCTOR: Because this question asks students to identify which element does not impact the calculation of the basic allowance for sampling risk, the response labeled ―correct‖ does not impact the calculation and those labeled ―incorrect‖ do impact the calculation. a.

Correct

Incorrect

The amount of misstatement in an account balance or transaction is not considered in calculating the basic allowance for sampling risk. The risk of incorrect acceptance is considered in determining the confidence factor, which is included in the calculation of the basic allowance for sampling risk. The sample size affects the sampling interval, which is included in the calculation of the basic allowance for sampling risk. The sampling interval is included in the calculation of the basic allowance for sampling risk.

SOLUTIONS FOR EXERCISES AND PROBLEMS F.44

Sample Selection: Monetary Unit Sampling a.

(1)

Washburn would first select a random starting point within the population, using either a random number table or computerized random number generator. The logical unit containing this dollar would be the first selection.

(2)

Washburn would then calculate the sampling interval by dividing the population size (recorded account balance) by the necessary sample size. Washburn would then bypass this number of items prior to making the next selection. As in (1), the logical unit containing this dollar would be the next selection.

(3)

The procedure in (2) would be repeated until the appropriate number of logical units (equal to the necessary sample size of 20) is selected.

The first four dollars would be selected as follows: Sampling interval = Recorded balance ÷ Sample size Sampling interval = $3,500,000 ÷ 20 = $175,000 Dollar 1: Dollar 2: Dollar 3: Dollar 4:

172,600 (random start) 347,600 (172,600 + 175,000) 522,600 (347,600 + 175,000) 697,600 (522,600 + 175,000)

Washburn would evaluate these items by sending a confirmation to the customer, requesting that the customer confirm the entire balance containing the logical unit selected from Anaheim Company‘s accounts receivable list. c.

If two dollars from the same logical unit (customer account) are selected, Washburn would send a confirmation to that customer and request confirmation of the entire account balance. In this case, the confirmation would represent two selections.

If the population were arranged by customer number or customer name, no additional procedures would be necessary prior to selecting the sample because there is no reason to believe that the related accounts receivable are not randomly sequenced with respect to either dollar amount or collectability. If the population were arranged based on either account balance or account status, Washburn would need to resequence the population in a random order (by either customer name or customer number).

F.45

Sample Selection: Monetary Unit Sampling. The sampling process begins by calculating the sampling interval. The sampling interval is calculated by dividing the recorded balance of the account balance (in this case, $38,610) by the appropriate sample size (10 items); the resulting sampling interval is $3,861 ($38,610  10 items = $3,861). Using a random start of 1,210, the sample items selected would be as follows:

ID 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Recorded Amount $1,750 1,492 994 629 2,272 1,163 1,255 3,761 1,956 1,393 884 729 937 5,938

Cumulative Amount $ 1,750 3,242 4,236 4,865 7,137 8,300 9,555 13,316 15,272 16,665 17,549 18,278 19,215 25,153

15 16 17 18 19 20 21 22 23

2,001 222 1,738 1,228 2,577 1,126 565 2,319 1,681

27,154 27,376 29,114 30,342 32,919 34,045 34,610 36,929 38,610

Total

Dollar Selected 1,210

Selected? Yes

Logical Unit $1,750

5,071

Yes

2,272

8,932 12,793

Yes Yes

1,255 3,761

16,654

Yes

1,393

20,515 24,376

Yes* Yes*

5,938

28,237

Yes

1,738

32,098

Yes

2,577

35,959 39,820

Yes

2,319

$ 23,003

*Two dollar units in the same logical unit NOTE TO INSTRUCTOR: This illustrates a basic advantage of MUS. You selected 10 of the 23 items (less than 50 percent) yet obtained coverage of $23,003 of the $38,610 account balance (almost 60 percent).

F.46

Sample Size Determination: Monetary Unit Sampling The following calculations use the MUS sample size table in Exhibit FA.1: Ratio of expected to tolerable misstatement = Expected Misstatement ÷ Tolerable Misstatement  

Scenarios (a) and (c): $10,000 ÷ $50,000 = 0.20 Scenarios (b) and (d): $25,000 ÷ $50,000 = 0.50

Tolerable misstatement as a percentage of population = Tolerable Misstatement ÷ Population 

All scenarios: $50,000 ÷ $500,000 = 0.10 Scenario

RIA

a. b. c. d.

0.05 0.05 0.10 0.10

EM TM 0.20 0.50 0.20 0.50

TM Population 0.10 0.10 0.10 0.10

Sample size 47 116 35 80

Scenarios (a) and (b) differ only with respect to expected misstatement. As the expected misstatement increases from $10,000 [scenario (a)] to $25,000 [scenario (b)], the sample size increases from 47 items to 116 items. Therefore, expected misstatement has a direct relationship with sample size. Scenarios (a) and (c) differ only with respect to the risk of incorrect acceptance. As the risk of incorrect acceptance increases from 5 percent [scenario (a)] to 10 percent [scenario (c)], the sample size decreases from 47 items to 35 items. Therefore, the risk of incorrect acceptance has an inverse relationship with sample size. Scenarios (b) and (d) differ only with respect to the risk of incorrect acceptance. As the risk of incorrect acceptance increases from 5 percent [scenario (b)] to 10 percent [scenario (d)], the sample size decreases from 116 items to 80 items. Therefore, the risk of incorrect acceptance has an inverse relationship with sample size. NOTE TO INSTRUCTOR: This is similar to the conclusion drawn by comparing scenarios (a) and (c).

F.47

Sample Size and Sampling Interval Determination: Monetary Unit Sampling a.

In determining sample size, Simmons should consider the recorded balance of the account, the acceptable level of the risk of incorrect acceptance, the tolerable misstatement, and the expected misstatement.

The recorded balance is determined by referring to Ace‘s accounting records. The risk of incorrect acceptance is determined by using the audit risk model and prior assessments of audit risk, risk of material misstatement, and analytical procedures risk. Simmons determines the tolerable misstatement judgmentally after considering the recorded balance of the account balance and class of transactions as well as the relationship between the account balance and class of transactions with important financial statement subtotals (such as total assets, total sales, and net income). The expected misstatement is based on Simmons‘s prior experiences with Ace (if the engagement is a recurring engagement) or a small preliminary sample (referred to as a pilot sample) if this is a first-year engagement.

Using Exhibit FA.1, the necessary sample size for the audit of Ace‘s inventory:   

Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.20 ($20,000 ÷ $100,000) Tolerable misstatement as a percentage of population = 8.3 percent ($100,000 ÷ $1,200,000)

Sample size ranges from 47 (tolerable misstatement 10 percent of population) to 58 (tolerable misstatement 8 percent of population); to interpolate (see Appendix FA) 0.10 – 0.08 = 0.02 (0.083 – 0.08) / 0.02 = 0.15 (58 - 47) x 0.15 = 1.65 58 – 1.65 = 57 (rounded up) d.

The appropriate sampling interval is determined as: Sampling interval = Recorded balance  Sample size Sampling interval = $1,200,000  57 = $21,052 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 58, the sampling interval would be $20,689 (rounded) ($1,200,000  58).

Simmons would select the sample from a computerized inventory list that Ace maintains between 0 and 21,052 and select a dollar in the computerized inventory list corresponding to that dollar. Simmons would then select every 21,052nd dollar in the inventory list until he had selected a total of 57 dollar units.

F.48

Sample Size and Sampling Interval Determination: Monetary Unit Sampling a.

Using Exhibit FA.1 and:   

Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.40 ($10,000 ÷ $25,000) Tolerable misstatement as a percentage of population = 8.3 percent ($25,000 ÷ $300,000)

Sample size ranges from 58 (tolerable misstatement 10 percent of population) to 72 (tolerable misstatement 8 percent of population); to interpolate (see Appendix FA) 0.10 – 0.08 = 0.02 (0.083 – 0.08) / 0.02 = 0.15 (72 – 58) x 0.15 = 2.1 72 – 2.1 = 70 (rounded up) b.

Sampling interval = Recorded balance  Sample size Sampling interval = $300,000  70 = $4,285 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 72, the sampling interval would be $4,167 (rounded) ($300,000  72).

Paul would randomly select a starting point between 0 and 4,285 and select a dollar in the computerized accounts receivable list corresponding to that dollar. He would then select every 4,285th dollar in the inventory list until a total of 70 dollar units were selected.

Reducing the risk of incorrect acceptance to 5 percent would increase the sample size and decrease the sampling interval as shown here:   

Risk of incorrect acceptance = 5 percent, Ratio of expected to tolerable misstatement = 0.40 ($10,000 ÷ $25,000) Tolerable misstatement as a percentage of population = 8.3 percent ($25,000 ÷ $300,000)

Sample size ranges from 81 (tolerable misstatement 10 percent of population) to 102 (tolerable misstatement 8 percent of population); to interpolate (see Appendix FA) 0.10 – 0.08 = 0.02 (0.083 – 0.08) / 0.02 = 0.15 (102 - 81) x 0.15 = 3.15 102 – 3.15 = 99 (rounded up) Sampling interval = Recorded balance  Sample size Sampling interval = $300,000  99 = $3,030 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 102, the sampling interval would be $2,941 (rounded) ($300,000  102).

Increasing the expected misstatement to $12,500 would increase the sample size and decrease the sampling interval as shown here:   

Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.50 ($12,500 ÷ $25,000) Tolerable misstatement as a percentage of population = 8.3 percent ($25,000 ÷ $300,000)

Sample size ranges from 80 (tolerable misstatement 10 percent of population) to 100 (tolerable misstatement 8 percent of population); to interpolate (see Appendix FA) 0.10 – 0.08 = 0.02 (0.083 – 0.08) / 0.02 = 0.15 (100 - 80) x 0.15 = 3 100 – 3 = 97 Sampling interval = Recorded balance  Sample size Sampling interval = $300,000  97 = $3,092 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 100, the sampling interval would be $3,000 ($300,000  100).

Decreasing tolerable misstatement to $20,000 would increase the sample size and decrease the sampling interval as shown here:   

Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.50 ($10,000  $20,000) Tolerable misstatement as a percentage of population = 6.7 percent ($20,000  $300,000)

Sample size ranges from 100 (tolerable misstatement 8 percent of population) to 134 (tolerable misstatement 6 percent of population); to interpolate (see Appendix FA) 0.08 – 0.06 = 0.02 (0.067 – 0.06) / 0.02 = 0.35 (134 - 100) x 0.35 = 11.9 134 – 11.9 = 123 (rounded up) Sampling interval = Recorded balance  Sample size Sampling interval = $300,000  123 = $2,439 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 134, the sampling interval would be $2,238 (rounded) ($300,000  134).

F.49

Sample Size and Sampling Interval Determination: Monetary Unit Sampling a.

Using Exhibit FA.1 and:   

Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.20 ($50,000  $250,000) Tolerable misstatement as a percentage of population = 2.5 percent ($250,000  $10,000,000)

Sample size ranges from 155 (tolerable misstatement 3 percent of population) to 232 (tolerable misstatement 2 percent of population); to interpolate (see Appendix FA) 0.03 – 0.02 = 0.01 (0.025 – 0.02) / 0.01 = 0.50 (232 - 155) x 0.50 = 38.5 232 - 28.5 = 194 (rounded up) Sampling interval = Recorded balance ÷ Sample size Sampling interval = $10,000,000 ÷ 194 = $51,546 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 232, the sampling interval would be $43,103 (rounded) ($10,000,000  232). b.

Drake would first select a random starting point within the population using either a random number table or computerized random number generator. The logical unit containing this dollar would be Drake‘s first selection. Drake would then bypass (or ―skip‖) 51,546 dollars in the population and make an additional selection; as with the first item, the logical unit containing this dollar would be the next selection. This process would be repeated until 194 items (the necessary sample size) are selected.

Using Exhibit FA.1 and modifying the risk of incorrect acceptance to 10 percent: Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.20 ($50,000  $250,000) Tolerable misstatement as a percentage of population = 2.5 percent ($250,000  $10,000,000) Sample size ranges from 114 (tolerable misstatement 3 percent of population) to 171 (tolerable misstatement 2 percent of population); to interpolate (see Appendix FA) 0.03 – 0.02 = 0.01 (0.025 – 0.02) / 0.01 = 0.50 (171 – 114) x 0.50 = 28.5 171 – 28.5 = 143 (rounded up) Sampling interval = $10,000,000 ÷ 143 = $69,930 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 171, the sampling interval would be $58,479 (rounded) ($10,000,000  171).

Using Exhibit FA.1 and decreasing tolerable misstatement to $125,000: Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.40 ($50,000 ÷ $125,000) Tolerable misstatement as a percentage of population = 1.25 percent ($125,000 ÷ $10,000,000) Sample size ranges from 405 (tolerable misstatement 2 percent of population) to 809 (tolerable misstatement 1 percent of population); to interpolate (see Appendix FA) 0.02 – 0.01 = 0.01 (0.0125 – 0.01) / 0.01 = 0.25 (809 – 405) x 0.25 = 101 809 – 101 = 708 Sampling interval = $10,000,000 ÷ 708 = $14,124 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 809, the sampling interval would be $12,360 (rounded) ($10,000,000  809).

Using Exhibit FA.1 and decreasing the expected misstatement to $25,000: Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.10 ($25,000  $250,000) Tolerable misstatement as a percentage of population = 2.5 percent ($250,000 ÷ $10,000,000) Sample size ranges from 123 (tolerable misstatement 3 percent of population) to 184 (tolerable misstatement 2 percent of population); to interpolate (see Appendix FA) 0.03 – 0.02 = 0.01 (0.025 – 0.02) / 0.01 = 0.50 (184 – 123) x 0.50 = 30.5 184 – 30 = 154 (rounded up) Sampling interval = $10,000,000 ÷ 154 = $64,935 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 184, the sampling interval would be $54,347 (rounded) ($10,000,000  184).

F.50

The relationship between each of these factors and sample size can be identified by comparing the sample sizes in (c) with that calculated in (a), as follows (assuming interpolation was used): 

The decrease in sample size from 194 to 143 [see (c)(1)] when the acceptable risk of incorrect acceptance increases from 5 percent to 10 percent indicates that the risk of incorrect acceptance has an inverse relationship with sample size.



The increase in sample size from 194 to 708 [see (c)(2)] when the tolerable misstatement decreases from $250,000 to $125,000 indicates that the tolerable misstatement has an inverse relationship with sample size.



The decrease in sample size from 194 to 154 [see (c)(3)] when the expected misstatement decreases from $50,000 to $25,000 indicates that expected misstatement has a direct relationship with sample size.

Sample size and the sampling interval have an inverse relationship (that is, as sample size increases, the sampling interval decreases and vice versa). This relationship is observed because, if a larger sample must be taken from within the sample population, a smaller number of items (sampling interval) will need to be bypassed in order to select the additional items.

Sample Size Relationships: Monetary Unit Sampling All of these relationships can be determined by using the sampling interval formula (Sampling interval = Recorded balance  Sample size). A.

Sampling interval = $1,500,000  115 Sampling interval = $13,043 (rounded)

$4,222 = $190,000  Sample size Sample size = 45 items

$18,000 = Recorded balance  124 Recorded balance = $2,232,000

F.51

Sample Size Relationships: Monetary Unit Sampling a.

Using Exhibit FA.1 and: Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.50 ($10,000 ÷$20,000) Tolerable misstatement as a percentage of population = 5 percent ($20,000 ÷$400,000) Sample size = 231

Some options that Frehley could use to reduce the sample size include:   

Increasing the acceptable level of the risk of incorrect acceptance. Increasing the level of tolerable misstatement. Decreasing estimates of expected misstatement.

Using Exhibit FA.1 and: Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.50 ($10,000 ÷ $20,000) Tolerable misstatement as a percentage of population = 5 percent ($20,000 ÷$400,000) Sample size = 160

F.52

Projected Misstatement Calculation: Monetary Unit Sampling These relationships can be determined through the use of the following two formulas: Tainting percentage = (Recorded balance – Audited value)  Recorded balance Projected misstatement = Tainting percentage x Sampling interval a.

Tainting percentage = ($15,000 – $12,000)  $15,000 = 0.20, or 20 percent.

Projected misstatement = 0.20 x $50,000 = $10,000

0.05 = ($30,000 – Audited value)  $30,000 Audited value = $28,500

$5,000 = 0.05 x Sampling interval Sampling interval = $100,000

0.25 = (Recorded balance – $6,000)  Recorded balance Recorded balance = $8,000

Projected misstatement = 0.25 x $25,000 = $6,250

NOTE TO INSTRUCTOR: Must work (h) prior to working (g). 0.50 [see h)] = ($12,000 – Audited value)  $12,000 Audited value = $6,000

$24,000 = Tainting percentage x $48,000 Tainting percentage = 0.50 or 50 percent

F.53

Upper Limit on Misstatements Calculation: Monetary Unit Sampling a.

Calculation of tainting percentage: Item 1: Would not calculate a tainting percentage because the logical unit exceeds the sampling interval. Item 2: ($10,000 – $4,000)  $10,000 = 0.60 Item 3: ($3,000 – $2,000)  $3,000 = 0.3333

Risk of incorrect acceptance = 5 percent Projected misstatement Item 1 2 3

Tainting % x

Sampling Interval

N/A 0.6000 0.3333

N/A $12,300 $12,300

= = =

x x x

Projected Misstatement $

2,500 7,380 4,100 13,980

Incremental allowance for sampling risk:

Item

Projected Misstatement

2 3

$7,380 4,100

Incremental Factor minus 1 x x

Incremental Allowance

(4.75 – 3.00 – 1) (6.30 – 4.75 – 1)

= =

$ $

5,535 2,255 7,790

Basic allowance for sampling risk: Sampling interval x Confidence factor $12,300 x 3.00 = $36,900 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk .......................

13,980 7,790 36,900

Upper limit on misstatements..............................

58,670

Risk of incorrect acceptance = 10 percent Projected misstatement:

Item 1 2 3

Tainting % x

Sampling Interval

N/A 0.6000 0.3333

N/A $12,300 $12,300

= = =

x x x

Projected Misstatement $

2,500 7,380 4,100 13,980

Incremental allowance for sampling risk:

Item

Projected Misstatement

2 3

$7,380 4,100

Incremental Factor minus 1 x x

Incremental Allowance

(3.89 – 2.31 – 1) (5.33 – 3.89 – 1)

= =

$ $

4,281 1,804 6,085

Basic allowance for sampling risk: Sampling interval x Confidence factor $12,300 x 2.31 = $28,413

Upper limit on misstatements:

Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk .......................

13,980 6,085 28,413

Upper limit on misstatements..............................

48,478

Based on the preceding computations, it appears that the upper limit on misstatements has an inverse relationship with the risk of incorrect acceptance; that is, as the risk of incorrect acceptance decreases, the upper limit on misstatements increases (and vice versa).

F.54

Upper Limit on Misstatements Calculation: Monetary Unit Sampling a.

Calculation of tainting percentage Item 1: Would not calculate a tainting percentage because the logical unit exceeds the sampling interval. Item 2: ($10,000 – $8,000)  $10,000 = 0.20 Item 3: ($6,000 – $3,000)  $6,000 = 0.50 Projected misstatement:

Item

Tainting %

Sampling Interval

1 2 3

N/A 0.20 0.50

x x x

N/A $25,000 $25,000

= = =

Projected Misstatement $

7,000 5,000 12,500 24,500

Incremental allowance for sampling risk:

Item

Projected Misstatement

3 2

$12,500 5,000

Incremental Factor minus 1 x x

Incremental Allowance

(4.75 – 3.00 – 1) (6.30 – 4.75 – 1)

= =

$ $

9,375 2,750 12,125

Basic allowance for sampling risk: Sampling interval x Confidence factor $25,000 x 3.00 = $75,000

Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

24,500 12,125 75,000

Upper limit on misstatements .............................

111,625

In this instance, a 95 percent probability (1 minus the risk of incorrect acceptance of 5 percent) that the true amount of misstatement in the account balance is less than or equal to $111,625 exists. Conversely, a 5 percent probability (risk of incorrect acceptance) that the true amount of misstatement in the account balance is more than $111,625 exists.

Because the upper limit on misstatements ($111,625) is less than the tolerable misstatement ($120,000), Allister would conclude that Bird‘s accounts receivable are fairly stated.

F.55

Upper Limit on Misstatements Calculation: Monetary Unit Sampling a.

All of the misstatements should be considered in the upper limit on misstatements calculation.

b. Account

Recorded Amount

Misstatement

Tainting %

2333 363 1216 2003

$8,345 $7,460 $19,450 $9,700

$1,669 $1,865 $1,945 $1,455

0.20 0.25 0.10 0.15

Projected misstatement: Account

Tainting % x

Sampling Interval

2333 363 1216 2003

0.20 0.25 0.10 0.15

$280,000 $280,000 $280,000 $280,000

= = = =

x x x x

Projected Misstatement $

56,000 70,000 28,000 42,000 $ 196,000

Incremental allowance for sampling risk:

Account

Projected Misstatement

363 2333 2003 1216

$70,000 56,000 42,000 28,000

Incremental Factor minus 1 x x x x

Incremental Allowance

(4.75 – 3.00 – 1) (6.30 – 4.75 – 1) (7.76 – 6.30 – 1) (9.16 – 7.76 – 1)

= = = =

52,500 30,800 19,320 11,200 113,820

Basic allowance for sampling risk: Sampling interval x Confidence factor $280,000 x 3.0 = $840,000 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

196,000 113,820 840,000

Upper limit on misstatements .............................

$ 1,149,820

Because the upper limit on misstatements ($1,149,820) exceeds the tolerable misstatement of $1,000,000, the auditors are unable to conclude that the account balance is fairly stated. An adjustment of $149,820 ($1,149,820 – $1,000,000 = $149,820) would be necessary in order for the auditors to conclude that the account balance is fairly stated. c.

F.56

The misstatement of account 1216 was due to employee fraud and should be reported to the accounting clerk‘s supervisor. Because the amount is not significant, it probably does not have to be reported to the audit committee. The misstatement of account 2003 may be part of a larger scheme to overstate sales and commissions. The auditors should consider bringing in a forensic expert to determine the scope of the problem. Assuming directions for overstating sales came from management, this should be reported to the audit committee. If it doesn‘t pursue the matter, the auditors should consider resigning from the engagement.

Upper Limit on Misstatements Calculations: Monetary Unit Sampling All of the calculations would use the following calculation of projected misstatement:

Item

Misstatement

X-21 Z-24 AA-02

$ 1,800  110  4,500 

Account Balance

Tainting %

$3,000 550 6,000

= = =

0.60 0.20 0.75

Sampling Interval =

Projected Misstatement

$10,000 10,000 10,000

x x x

= = =

$ a.

6,000 2,000 7,500 15,500

Incremental allowance for sampling risk:

Account

Projected Misstatement

Incremental Factor minus 1

Incremental Allowance

AA-02 X-21 Z-24

$7,500 x 6,000 x 2,000 x

(6.64 – 4.61 – 1.00) (8.41 – 6.64 – 1.00) (10.05 – 8.41 – 1.00)

= = =

7,725 4,620 1,280 13,625

Basic allowance for sampling risk: Sampling interval x Confidence factor $10,000 x 4.61 = $46,100

15,500 13,625 46,100

Upper limit on misstatements .............................

75,225

Incremental allowance for sampling risk:

Account

Projected Misstatement

Incremental Factor minus 1

AA-02 X-21 Z-24

$7,500 6,000 2,000

(4.75 – 3.00 – 1.00) (6.30 – 4.75 – 1.00) (7.76 – 6.30 – 1.00)

x x x

Incremental Allowance = = =

5,625 3,300 920 9,845

Basic allowance for sampling risk: Sampling interval x Confidence factor $10,000 x 3.0 = $30,000 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

15,500 9,845 30,000

Upper limit on misstatements .............................

55,345

Comparing the upper limit on misstatements shown in (a) and (b) above, the risk of incorrect acceptance has an inverse relationship with the upper limit on misstatements (as the risk of incorrect acceptance decreases, the upper limit on misstatements increases).

F.57

Upper Limit on Misstatements Calculations: Monetary Unit Sampling a.

Calculation of tainting percentage:

Item

Recorded Amount

Audited Amount

Tainting %

10-865 20-954 30-781 40-269

$12,600 $110,000 $55,000 $80,000

$8,400 $95,000 $44,000 $60,000

0.3333 N/A 0.2000 0.2500

Projected misstatement

Item 20-954 10-865 40-269 30-781

Tainting % x

Sampling interval

N/A 0.3333 0.2500 0.2000

N/A $100,000 100,000 100,000

= = = =

x x x x

Projected Misstatement $

15,000 33,333 25,000 20,000 93,333

Incremental allowance for sampling risk:

Item

Projected Misstatement

10-865 40-269 30-781

$33,333 25,000 20,000

Incremental Factor minus 1 x x x

Incremental Allowance

(4.75 – 3.00 – 1) (6.30 – 4.75 – 1) (7.76 – 6.30 – 1)

= = =

25,000 13,750 9,200 47,950

Basic allowance for sampling risk: Sampling interval x Confidence factor $100,000 x 3.00 = $300,000

Upper limit on misstatements:

Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

93,333 47,950 300,000

Upper limit on misstatements .............................

441,283

The upper limit on misstatements calculated in (a) is an estimate of the misstatement that has a (1 minus risk of incorrect acceptance) probability of equaling or exceeding the true amount of misstatement in the population. In this case, there is a 95 percent probability that the amount of misstatement in the population is less than or equal to $441,283.

The tainting percentages and projected misstatement ($93,333) would be the same as those calculated in (a). The only difference introduced by modifying the risk of incorrect acceptance is in the calculation of the incremental allowance for sampling risk and basic allowance for sampling risk.

Risk of incorrect acceptance = 10 percent Incremental allowance for sampling risk:

Item

Projected Misstatement

10-865 40-269 30-781

$33,333 25,000 20,000

Incremental Factor minus 1 x x x

Incremental Allowance

(3.89 – 2.31 – 1) (5.33 – 3.89 – 1) (6.69 – 5.33 – 1)

= = =

19,333 11,000 7,200 37,533

Basic allowance for sampling risk: Sampling interval x Confidence factor $100,000 x 2.31 = $231,000

Upper limit on misstatements:

Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

93,333 37,533 231,000

Upper limit on misstatements .............................

361,866

As the acceptable level of the risk of incorrect acceptance increases, the upper limit on misstatements decreases; that is, the risk of incorrect acceptance has an inverse relationship with the upper limit on misstatements. If Billy establishes lower acceptable levels of the risk of incorrect acceptance, he decreases the likelihood that he will conclude that an account balance is fairly stated when, in fact, it is materially misstated. Because he will compare the upper limit on misstatements to the tolerable misstatement, a higher upper limit on misstatements will reduce the likelihood that Billy will conclude that the account balance is fairly stated, decreasing his exposure to the risk of incorrect acceptance. Alternatively, if Billy accepts higher levels of the risk of incorrect acceptance, he increases the likelihood of concluding that an account balance is fairly stated when, in fact, it is materially misstated. In this case, the lower upper limit on misstatements will increase the likelihood that Billy will conclude that the account balance is fairly stated, increasing his exposure to the risk of incorrect acceptance.

The advantage of establishing lower acceptable levels of the risk of incorrect acceptance is the lower likelihood of concluding that an account balance is fairly stated when, in fact, it is materially misstated. This, in turn, will result in the lower likelihood that Billy is exposed to litigation or damaged professional reputation. The disadvantage of establishing lower acceptable levels of the risk of incorrect acceptance is that Billy is more likely to initially conclude that the account balance is misstated, holding all other factors constant. This conclusion may result in Billy‘s performing additional substantive procedures to corroborate his conclusion. Conversely, the increased exposure to litigation or damaged professional reputation is a disadvantage of establishing higher acceptable levels of the risk of incorrect acceptance. Also, the lower likelihood of performing additional substantive procedures is an advantage of establishing higher acceptable levels of the risk of incorrect acceptance.

F.58

Comprehensive Problem: Monetary Unit Sampling a.

It appears that the use of MUS is appropriate in this situation for the following reasons: 

In the audit of accounts receivable, overstatement is of more concern to the audit team than understatement. MUS is more effective than other methods (such as classical variables sampling) in detecting overstatements.



The extent of misstatement (2 percent, or $100,000 ÷ $5,000,000) is relatively small. MUS is relatively effective when few or no misstatements are anticipated.

In addition to these characteristics, the use of MUS is more appropriate when (1) it is difficult or impractical to estimate the standard deviation and (2) the population is heterogeneous and includes some relatively large (in terms of dollar amounts) items. These features of Foley‘s accounts receivable balances cannot be determined by information provided in the problem. b.

Using Exhibit FA.1 and:   

Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.20 ($100,000 ÷ $500,000) Tolerable misstatement as a percentage of population = 10 percent ($500,000 ÷ $5,000,000)

Sample size = 35 Sampling interval = Recorded balance ÷ Sample size Sampling interval = $5,000,000 ÷ 35 = $142,857 (rounded) c.

Mayo began by selecting a random starting point within the population; the logical unit containing that dollar would be his first selection. He then bypassed 142,857 items (equal to the sampling interval) and selected the logical unit containing this dollar. This procedure was repeated until 35 individual dollars (and the accompanying logical units) were selected. Because the random starting point within the population was not documented, it is impossible to replicate Mayo‘s sample or otherwise determine the customer balances he confirmed (other than those who replied to the positive confirmation with exceptions).

Calculation of tainting percentage:

Customer

Recorded Balance

Audited Balance

Tainting %

R. Gerer D. Wings L. Goss K. David

$ 15,000 25,000 60,000 120,000

$10,000 20,000 30,000 90,000

0.3333 0.2000 0.5000 0.2500

Projected misstatement:

Customer

Tainting % x

Sampling Interval

L. Goss R. Gerer K. David D. Wings

0.5000 0.3333 0.2500 0.2000

$142,857 $142,857 $142,857 $142,857

= = = =

Item

Projected Misstatement

L. Goss R. Gerer K. David D. Wings

$71,429 47,615 35,715 28,572

x x x x

Projected Misstatement $ 71,429 47,615 35,715 28,572 $183,331

Incremental Factor minus 1 x x x x

Incremental Allowance

(3.89 – 2.31 – 1) (5.33 – 3.89 – 1) (6.69 – 5.33 – 1) (8.00 – 6.69 – 1)

= = = =

41,429 20,951 12,858 8,858 84,096

Basic allowance for sampling risk: Sampling interval x Confidence factor $142,857 x 2.31 = $330,000 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

183,331 84,096 330,000

Upper limit on misstatements .............................

597,427

Based on the upper limit on misstatements, you would conclude that there is a 90 percent likelihood (1 minus risk of incorrect acceptance of 10 percent) that the true misstatement in Foley‘s accounts receivable is less than or equal to $597,427.

Because the upper limit on misstatements ($597,427) exceeds the tolerable misstatement ($500,000), your initial conclusion would be that Foley‘s accounts receivable balance is not fairly stated. At this point, you could either (1) increase your sample size and examine additional items or (2) recommend adjustment to the recorded balance of Foley‘s accounts receivable.

Expected misstatement: Because of the high level of turnover in its sales processing personnel, the large sales that present some revenue recognition issues, and the increase in accounts receivable balance (which may reflect uncollectible accounts receivable or fictitious sales), it appears that the expected misstatement in the current year may be higher than that observed in prior audits. Tolerable misstatement: The decline in the current and quick ratios and their closeness to debt covenants suggest that the level of tolerable misstatement in the current year should be lower than that used in prior audits. Risk of incorrect acceptance: The issues related to turnover in sales processing personnel indicate increased risk of material misstatement; the more limited use of analytical procedures during the current audit indicates increased analytical procedures risk. Considered together, these factors suggest that the risk of incorrect acceptance in the current audit should be lower than that used in prior audits (if audit risk is to be maintained at similar levels).

F.59

Each of the factors noted in (f) would increase the necessary sample size. In addition, the lower risk of incorrect acceptance would result in an increase in the upper limit on misstatements.

Comprehensive Problem: Monetary Unit Sampling a.

Using Exhibit FA.1, the following are the sampling interval and sample size that Walker would use:   

Risk of incorrect acceptance = 10 percent Ratio of expected to tolerable misstatement = 0.3333 ($50,000 ÷ $150,000) Tolerable misstatement as a percentage of population = 10 percent ($150,000 ÷ $1,500,000)

Sample size ranges from 44 (ratio of expected misstatement to tolerable misstatement of 0.30) to 58 (ratio of expected misstatement to tolerable misstatement of 0.40); to interpolate (see Appendix FA) 0.40 – 0.30 = 0.10 (0.40 – 0.3333) / 0.10 = 0.667 (58 – 44) x 0.667 = 9.4 58 – 9.4 = 49 (rounded up) Sampling interval = Recorded balance  Sample size Sampling interval = $1,500,000  49 = $30,612 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 58, the sampling interval would be $25,862 (rounded) ($1,500,000  58).

For a risk of incorrect acceptance = 5 percent and  

Ratio of expected to tolerable misstatement = 0.3333 ($50,000 ÷ $150,000) Tolerable misstatement as a percentage of population = 10 percent ($150,000 ÷ $1,500,000)

Sample size ranges from 60 (ratio of expected misstatement to tolerable misstatement of 0.30) to 81 (ratio of expected misstatement to tolerable misstatement of 0.40); to interpolate (see Appendix FA) 0.40 – 0.30 = 0.10 (0.40 – 0.3333) / 0.10 = 0.667 (81 – 60) x 0.667 = 14 81 – 14 = 67 Sampling interval = Recorded balance  Sample size Sampling interval = $1,500,000  67 = $22,388 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 81, the sampling interval would be $18,518 (rounded) ($1,500,000  81).

Risk of incorrect acceptance = 20 percent and  

Ratio of expected to tolerable misstatement = 0.3333 ($50,000 ÷ $150,000) Tolerable misstatement as a percentage of population = 10 percent ($150,000 ÷ $1,500,000)

Sample size ranges from 28 (ratio of expected misstatement to tolerable misstatement of 0.30) to 36 (ratio of expected misstatement to tolerable misstatement of 0.40); to interpolate (see Appendix FA) 0.40 – 0.30 = 0.10 (0.40 – 0.3333) / 0.10 = 0.667 (36 – 28) x 0.667 = 5.33 36 – 5.33 = 31 (rounded up) Sampling interval = Recorded balance  Sample size Sampling interval = $1,500,000  31 = $48,387 (rounded) NOTE TO INSTRUCTOR: If students did not interpolate and used the conservative (high) sample size of 36, the sampling interval would be $41,666 (rounded) ($1,500,000  36).

Evaluating the responses to (a) and (b), it appears that the risk of incorrect acceptance (RIA) has an inverse relationship with sample size (n) and a direct relationship with the sampling interval (SI), as shown here (assuming interpolation):

RIA

5% 10% 20%

67 49 31

$22,388 $30,612 $48,387

Projected misstatement: Misstatement $ 1,750  800  2,000 1,000 

Account Balance

Tainting %

Sampling Interval =

$3,500 1,000

= =

0.50 0.80

x x

$8,000 = 8,000 =

5,000

0.20

8,000

Projected Misstatement $

= $

4,000 6,400 2,000 1,600 14,000

Incremental allowance for sampling risk: Projected Misstatement $6,400 4,000 1,600

Incremental Factor minus 1 x x x

Incremental Allowance

(3.89 – 2.31 – 1.00) (5.33 – 3.89 – 1.00) (6.69 – 5.33 – 1.00)

= = =

3,712 1,760 576 6,048

Basic allowance for sampling risk: Sampling interval x Confidence factor $8,000 x 2.31 = $18,480 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

14,000 6,048 18,480

Upper limit on misstatements .............................

38,528

Risk of incorrect acceptance = 5 percent Incremental allowance for sampling risk: Projected Misstatement $6,400 4,000 1,600

Incremental Factor minus 1 x x x

Incremental Allowance

(4.75 – 3.00 – 1.00) (6.30 – 4.75 – 1.00) (7.76 – 6.30 – 1.00)

= = =

4,800 2,200 736 7,736

Basic allowance for sampling risk: Sampling interval x Confidence factor $8,000 x 3.0 = $24,000 Upper limit on misstatements:

Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

14,000 7,736 24,000

Upper limit on misstatements .............................

45,736

Risk of incorrect acceptance = 20 percent Incremental allowance for sampling risk: Projected Misstatement $6,400 4,000 1,600

Incremental Factor minus 1 x x x

Incremental Allowance

(3.00 – 1.61 – 1.00) (4.28 – 3.00 – 1.00) (5.52 – 4.28 – 1.00)

= = =

2,496 1,120 384 4,000

Basic allowance for sampling risk: Sampling interval x Confidence factor $8,000 x 1.61 = $12,880 Upper limit on misstatements: Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

14,000 4,000 12,880

Upper limit on misstatements .............................

30,880

Based on the calculations in (d) and (e), it appears that the risk of incorrect acceptance has an inverse relationship with the upper limit on misstatements. For example, the upper limit on misstatements for a risk of incorrect acceptance of 5 percent is $45,736; for a risk of incorrect acceptance of 20 percent, it is $30,880. f.

F.60

In all three instances, Walker would accept the accounts receivable balance as fairly recorded because the upper limit on misstatements is less than the tolerable misstatement of $150,000 ($1,500,000 x 0.10 = $150,000). However, because the upper limit on misstatements increases as the risk of incorrect acceptance decreases, a lower risk of incorrect acceptance would provide Walker a lower likelihood of concluding that the account balance is fairly stated.

Comprehensive Problem: Monetary Unit Sampling a.

In determining sample size, Mays should consider the recorded balance of the account, the acceptable level of the risk of incorrect acceptance, the tolerable misstatement, and the expected misstatement. These factors would be determined as follows: 

The recorded balance is determined by reference to Channel‘s accounting records.



The risk of incorrect acceptance is determined by using the audit risk model and prior assessments of audit risk, risk of material misstatement, and analytical procedures risk.



Mays determined the tolerable misstatement judgmentally after considering the recorded balance of the account balance and class of transactions as well as the relationship between the account balance and class of transactions with important financial statement subtotals (such as total assets, total sales, and net income).



The expected misstatement is based on prior experiences of Mays with Channel (if the engagement is a recurring engagement) or a small preliminary sample (referred to as a pilot sample) (if the engagement is a first-year engagement).

Based on the following parameters, a sample size of 78 would be appropriate   

Risk of incorrect acceptance = 5 percent Ratio of expected to tolerable misstatement = 0.20 ($24,000 ÷ $120,000) Tolerable misstatement as a percentage of population = 6 percent ($120,000 ÷ $2,000,000)

Sample Size = 78 Sampling interval = Recorded balance ÷ Sample size Sampling interval = $2,000,000 ÷ 78 = $25,641 (rounded) c.

Mays would identify a random number between 0 and 25,641 and select a dollar in Channel‘s computerized accounts receivable ledger corresponding to that number. Mays would then select every 25,651st dollar in the accounts receivable ledger until a total of 78 dollar units are selected.

d. Misstatement

Account Balance

$ 5,000 2,000  3,000 

Tainting %

$ 8,000 = 12,000 =

0.25 0.25

Sampling Projected Interval = Misstatement

x x

$ 5,000 3,250 3,250

$13,000 = 13,000 =

$ 11,500

e. Incremental allowance for sampling risk: Projected Misstatement $3,250 3,250

Incremental Factor minus 1 x x

Incremental Allowance

(4.75 – 3.00 – 1.00) (6.30 – 4.75 – 1.00)

= =

$ $

2,438 1,788 4,226

Basic allowance for sampling risk: Sampling interval x Confidence factor $13,000 x 3.00 = $39,000 Upper limit on misstatements:

Projected misstatement ....................................... Incremental allowance for sampling risk ............. Basic allowance for sampling risk ......................

11,500 4,226 39,000

Upper limit on misstatements .............................

54,726

Because the upper limit on misstatements ($54,726) is less than the tolerable misstatement ($120,000), Mays would conclude that Channel‘s accounts receivable were fairly stated.

F.61

Mistakes in a Monetary Unit Sampling Application 

MUS defines a sampling unit as each dollar in the population, not each account.



MUS is not efficient if many misstatements are expected because the sample size can become larger than the sample size for classical variables sampling.



Under MUS, each account does not have an equal chance of being selected; the probability of selection of the accounts is proportional to the dollar balances of these accounts.



MUS requires special consideration for negative (credit) balances.



The tolerable misstatement was not considered in calculating the sample size.



The expected misstatement was not considered in calculating the sample size.



The standard deviation of the dollar amounts is not required for MUS.



The three accounts with insignificant balances should not have been ignored or replaced with other accounts.



The account with the $1,000 difference (recorded balance of $4,000 and audited value of $3,000) was incorrectly projected as a $1,000 misstatement. The projected misstatement for this difference was actually $2,500 [($1,000  $4,000) x $10,000 sampling interval = $2,500].



The difference in the understated account (recorded balance of $1,900 and audited value of $2,000) should not have been omitted from the calculation of projected misstatement.



The decision basis (comparison of projected misstatement with the allowance for sampling risk) was erroneous, and the decision may be faulty. Mead should have compared the properly calculated upper limit on misstatements to the tolerable misstatement.

F.62

Monetary Unit Sampling a.

Yes. Generally accepted auditing standards note that either statistical or nonstatistical sampling can be used to provide sufficient audit evidence.

The advantages of statistical sampling are that this method helps Costanza (1) design an efficient sample, (2) measure the sufficiency of the evidence obtained, and (3) evaluate the sample results.

The two sampling risks associated with variables sampling are the risk of incorrect acceptance and the risk of incorrect rejection. The risk of incorrect acceptance is the likelihood that the sample results indicate the account balance is fairly stated when, in fact, it is materially misstated. The risk of incorrect rejection is the likelihood that the sample results indicate that the account balance is materially misstated when, in fact, it is fairly stated. The risk of incorrect acceptance exposes Costanza to an effectiveness loss because he will make an incorrect conclusion and issue an inappropriate opinion on the financial statements. The risk of incorrect rejection exposes the Costanza to an efficiency loss because additional transactions or components will be examined prior to proposing an adjustment to the financial statements.

Costanza would assess the appropriate level of the risk of incorrect acceptance through using the audit risk model. He would first specify the acceptable level of audit risk and then, based on the susceptibility of the account balance or class of transactions to misstatement, assess the appropriate level of inherent risk. After performing tests of controls, Costanza would then assess risk of material misstatement. Next, based on the planned effectiveness of his analytical procedures, Costanza would assess the risk associated with analytical procedures. Using the audit risk model, Costanza would mathematically ―solve‖ the audit risk model for the necessary level of the test of details risk, which is analogous to the risk of incorrect acceptance.

In planning a sample for a substantive procedure, Costanza should use his judgment to determine which items in an account balance or class of transactions should be individually examined and which should be subject to sampling. In particular, he should examine those items for which some sampling risk is not justified (such as items that have a potential misstatement equal to or greater than the tolerable misstatement).

To ensure that the sample items are representative of the population, all dollar units in the population should have an equal opportunity to be selected.

Some qualitative aspects of the misstatements that should be considered by Costanza include (1) the nature and cause of misstatements (for example, are the misstatements differences in principle or in application, are the misstatements instances of errors (unintentional) or fraud (intentional), or are the misstatements due to misunderstanding of instructions or carelessness) and (2) the possible relationship of the misstatements to other phases of the audit.

SOLUTIONS FOR IDEA EXERCISES AND PROBLEMS (F.63 – F.66) NOTE TO INSTRUCTOR: Videos illustrating how to load data into IDEA and the steps in using IDEA for these exercises are available on the Connect site. Prior to beginning Exercises F.63 and F.64, the data are loaded into IDEA as follows: 1.

Create a managed project in IDEA

Download the ―Module F ELM Required data and documents‖ zip file and extract the contents. This will contain the Sales 2020 – 4th Q database.

Copy the required data into the project file within Documents > My IDEA Documents > IDEA Projects > Project name (ELM Company Module F in this example).

Refresh the file list in IDEA to show the databases within your project:

Double-click on the database to open within IDEA.

F.63

Monetary Unit Sampling with IDEA: Determining Sample Size For parts (a) – (d), use the Analysis > Monetary Unit > Plan function, select the ―INVAMT‖ (Positive Values) field, and input the appropriate parameters for Confidence level, Tolerable error, and Expected error to determines the appropriate sample size. (The screen shot for the parameters in part (a) is shown below).

The appropriate sample size is 47 transactions.

The appropriate sample size is 36 transactions.

The appropriate sample size is 77 transactions.

The appropriate sample size is 32 transactions.

Comparing the sample sizes in parts (b), (c), and (d) to those in (a) reveals the following: The risk of incorrect acceptance has an inverse relationship with sample size. As the risk of incorrect acceptance increased from 10 percent to 15 percent, the sample size decreased from 47 transactions to 36 transactions. The tolerable misstatement has an inverse relationship with sample size. As the tolerable misstatement decreased from $311,711 to $233,783, the sample size increased from 47 transactions to 77 transactions. The expected misstatement has a direct relationship with sample size. As the expected misstatement decreased from $77,928 to $19,482, the sample size decreased from 47 transactions to 32 transactions.

F.64

Monetary Unit Sampling with IDEA: Determining Sample Size and Selecting Sample Items a.

Using the Analysis > Monetary Unit > Plan function and selecting the ―INVAMT‖ (Positive Values) field, inputting the Confidence level of 90%, Tolerable error of $389,638 (or 10%), and Expected error of $58,446 (or 1.5%), IDEA determines an appropriate sample size of 29 transactions.

From part (a) above, IDEA also calculates a sampling interval of $134,358. This is determined by dividing the population size (recorded balance of $3,896,384) by the sample size (29), or $3,896,384 ÷ 29 transactions = $134,358.

After determining the sample size in part (a), selecting ―Accept‖ will enable the Analysis > Monetary Unit > Extract function. The following fields are populated:      

Extraction Type (―Fixed interval‖) High value handling (―High values in database‖, with default file name ―High Values‖) Numeric field to sample (―INVAMT‖) Random starting point (IDEA selects a random number; modify to 5,678 for the problem requirement) Sample interval (134,358.06, carried over from sample selection) IDEA assigns the primary file a default file name ―Monetary Sample‖

The following ―Monetary Sample‖ transactions would be selected for examination:

The following ―High Values‖ transactions would be selected for examination:

Under MUS and IDEA sample extraction, the first item selected will be the transaction including the 5,678th dollar (the random start). IDEA will then select transactions containing the 140,036 th dollar (5,678 + 134,358 = 140,036), 274,394th dollar (140,036 + 134,358 = 274,394), etc.

Based on the selection process, a total of 28 transactions (20 non-high value transactions and 8 high value transactions) were selected; these transactions had a total recorded balance of $2,138,026.59. Given that the total recorded balance of the population of transactions was $3,896,383.85, the audit team has selected transactions comprising 55 percent of the population balance while examining only a small proportion (28 of 362, or 8 percent) of the transactions.

F.65

The high dollar transactions may account for more than one sample selection; that is, each transaction may contain more than one sampling unit (a dollar of an account balance or class of transactions). This is not a concern and is a normal characteristic of MUS.

Monetary Unit Sampling with IDEA: Evaluating Sample Results NOTE TO INSTRUCTOR: For this exercise, you will need to copy the Monetary Sample F.65 and High Values F.65 databases into the managed project created within IDEA (see below):

After refreshing the file list in IDEA and opening ―Monetary Sample F.65‖ and ―High Values F.65‖, enter the appropriate audited values (the values for part (a) are shown below): Entering Audited Values in Monetary Sample (screen shot is abbreviated to show items modified):

Entering Audited Values in High Values Sample (screen shot is abbreviated to show items modified):

With the ―Monetary Sample F.65‖ tab highlighted, use the Analysis > Monetary Unit > Evaluate > Stringer Bound function to determine the appropriate gross upper error limit (upper limit on misstatements). The following fields are populated by IDEA:     

Confidence Level Value of sampled population Sample size Book value field (Primary database, Monetary Sample) Audited value field (Primary database, Monetary Sample)

You will need to identify the ―High Values file‖ by browsing and selecting the ―High Values F.65‖ file from the Desktop Project Window. Once this has been done, IDEA will populate the Book value field and Audited value field for the High Value Items file.

The upper limit on misstatements (gross upper error limit in IDEA) is $240,639.37. Because this is less than the tolerable misstatement ($292,229), the audit team would conclude that ELM‘s sales transactions are fairly stated.

NOTE TO INSTRUCTOR: Screenshots for the parameters in (b) are similar to those for (a), with the exception of the discrepancies observed through the confirmation process. The upper limit on misstatements (gross upper error limit in IDEA) is $306,492.74. Because this is greater than the tolerable misstatement ($292,229), the audit team would conclude that ELM‘s sales transactions are not fairly stated.

F.66

Monetary Unit Sampling with IDEA: Comprehensive Problem NOTE TO INSTRUCTOR: For this exercise, you will need to copy the Sales 2020 – 4th Q, Monetary Sample F.66, and High Values F.66 databases into the managed project created within IDEA (see below):

Using the View > Field Statistics function and selecting ―Number of records‖ and ―Net value‖, IDEA reveals a total of 410 sales transactions in ELM‘s sales transaction file with a total recorded balance of $3,896,383.85.

ELM has 48 transactions that have a zero balance (this could also be determined by using the View > Field Statistics function and selecting ―Number of zero items‖). One of the limitations of MUS is that special considerations are required for transactions having zero or negative balances (there are no negative balances in ELM‘s transaction file).

ELM has 8 transactions with a balance in excess of $143,000, with the next highest balance being $98,994.63. One of the advantages of MUS is that it has a tendency to select larger dollar transactions for examination.

Use the Analysis > Monetary Unit > Plan function, select the ―INVAMT‖ (Positive Values) field, and input the appropriate parameters for Confidence level, Tolerable error, and Expected error to determine the appropriate sample size and sampling interval.

Sample Size

Sampling Interval

$86,586.31

$129,879.46

$121,762.00

$108,232.88

Comparing (2) to (1), as the tolerable misstatement increases, the sample size decreases. This demonstrates that tolerable misstatement has an inverse relationship with sample size. Comparing (3) to (1), as the expected misstatement decreases, the sample size decreases. This demonstrates that expected misstatement has a direct relationship with sample size. Comparing (4) to (1), as the risk of incorrect acceptance increases, the sample size decreases. This demonstrates that the risk of incorrect acceptance has an inverse relationship with sample size.

A total of 39 transactions were selected (26 non-high dollar transactions in the ―Monetary Sample‖ file and 13 high dollar transactions in the ―High Values‖ file).

In this case, the audit team selected approximately 11 percent of the transactions for examination (39 ÷ 362 = 11 percent). (Recall that the original population had 410 transactions, but 48 were for zero dollars). To determine the total dollar value of the transactions selected for examination, use the Properties Tab and Field Statistics function and selecting ―INVAMT‖, as shown below.

For Monetary Sample F.66:

For High Values Sample F.66:

IDEA reveals the total dollar value of the transactions selected was $2,384,511.47 ($680,135.27 for nonhigh dollar transactions and $1,704,376.20 for high dollar transactions); since the recorded balance of the population is $3,896,383.85, the transactions selected by the audit team represented 61 percent of the dollar value of the population ($2,384,511.47 ÷ $3,896,383.85 = 61 percent). The fact that 61 percent of the dollar value of the population was selected appears to provide adequate coverage of the population.

After opening ―Monetary Sample F.66‖ and ―High Values F.66‖, enter the appropriate audited values (the values for part (a) are shown below): Entering Audited Values in Monetary Sample (screen shot is abbreviated to focus on INVAMT and AUDIT_AMT columns and transactions where the recorded balance differed from the audited balance):

Entering Audited Values in High Values Sample (screen shot is abbreviated to focus on INVAMT and AUDIT_AMT columns and transactions where the recorded balance differed from the audited balance):

With the ―Monetary Sample F.66‖ tab highlighted, use the Analysis > Monetary Unit > Evaluate > Stringer Bound function to determine the appropriate gross upper error limit (upper limit on misstatements). The following fields are populated by IDEA:     

Confidence Level Value of sampled population Sample size Book value field (Primary database, Monetary Sample) Audited value field (Primary database, Monetary Sample)

You will need to identify the ―High Values file‖ by browsing and selecting the ―High Values F.66‖ file from the Desktop Project Window. Once this has been done, IDEA will populate the Book value field and Audited value field for the High Value Items file.

As shown below, the gross upper error limit (upper limit on misstatements) is $219,484.11. Since this is less than the tolerable misstatement, the audit team would conclude that sales transactions are fairly stated.

APPENDIX FB SOLUTIONS SOLUTIONS FOR REVIEW CHECKPOINTS FB.1

Classical variables sampling is an approach that uses the laws of probability and the central limit theorem to provide an estimate of either the amount of misstatement or the true balance of an account balance or class of transactions. The audit team uses the estimates of the account balance or class of transactions or misstatement in the account balance or class of transactions to determine whether the account balance or class of transactions is fairly stated.

FB.2

Mean-per-unit estimation assumes that each item in the population has an equal recorded balance. This method estimates the account balance by calculating an average audited value per item in the sample and multiplying that value by the number of items in the population. Ratio estimation assumes that each dollar in the population has an equal percentage of misstatement. This method estimates the account balance by multiplying the ratio of audited values to recorded balances in the sample by the recorded balance of the population. Difference estimation assumes that each item in the population has an equal dollar misstatement. This method estimates the account balance by calculating the average misstatement per item in the sample, multiplying that value by the number of items in the population, and adjusting the recorded account balance for this estimated misstatement.

FB.3

Under mean-per-unit estimation, ratio estimation, or difference estimation, the audit team would form an estimate of the account balance or class of transactions and, based on that estimate, determine a range that has a specified probability of including the true balance of the account or class of transactions. The difference between that range and the recorded balance is then compared to the tolerable misstatement to determine whether the account balance is fairly stated.

FB.4

Stratification is the process of subdividing a population into more homogenous subgroups (or strata) and reduces the necessary sample size in a classical variables sampling application Stratification is beneficial because it permits the audit team to reduce the appropriate sample size by reducing the variability within each stratum.

FB.5

The standard deviation is a measure of variability of the population calculated by summing the squared differences between each item in the population and the population mean and dividing by the sample size minus 1. The standard deviation has a direct relationship with sample size; that is, as the standard deviation increases, the sample size increases.

FB.6

Classical variables sampling methods explicitly incorporate the acceptable risk of incorrect rejection and the population variability (standard deviation) in the determination of sample size. MUS methods do not consider these factors.

FB.7

Under classical variables sampling, the sampling unit is defined as a logical unit comprising an account balance or class of transactions and not an individual dollar of an account balance or class of transactions.

FB.8

Precision is the amount from the estimated population value in which the true (but unknown) population value may lie with a given probability. Precision is determined arithmetically based on the (a) population size, b) risk of incorrect acceptance, (c) standard deviation, and (d) sample size. The precision interval, which is used in classical variables sampling, an interval of sample estimates that controls the audit team‘s exposure to the risk of incorrect acceptance and risk of incorrect rejection. It is the range of estimates that has a (1 minus risk of incorrect acceptance) probability of including the true account balance. This interval is determined by adding and subtracting the precision from the sample estimate of the account balance or class of transactions. Precision is determined arithmetically based on the (a) population size, (b) risk of incorrect acceptance, (c) standard deviation, and (d) sample size.

FB.9

The audit team compares the difference between the recorded balance and the furthest boundary of the precision interval to the tolerable misstatement. If the difference is higher than the tolerable misstatement, the audit team concludes the account may be materially misstated and either increases the sample size or requests the client to adjust the account balance.

FB.10

When selecting a variables sampling approach, the audit team should use MUS when (a) overstatement errors are of great concern, (b) it is difficult or impractical to estimate the standard deviation, (c) no or few misstatements are anticipated, and (d) the population is relatively heterogeneous with respect to the dollar amount of components and a number of relatively large dollar items exist. When selecting a variables sampling approach, the audit team should use classical variables sampling when (a) understatement errors are of concern, (b) the standard deviation can be estimated, (c) misstatements are anticipated, and (d) the population is relatively homogenous with respect to the dollar amount of components and relatively large dollar items do not exist.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS FB.11

FB.12

FB.13

a. b.

Incorrect Correct

Inorrect

Incorrect

Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

$480 is the amount of the actual misstatement, not the projected misstatement. To determine the projected misstatement, Rathermel would calculate the audited value of the inventory. The mean audited value per unit is $396 [($48,000 - $480)  120 units = $396), providing an audited value of the inventory balance of $475,200 (1,200 items x $396 = $475,200). The projected misstatement would be determined by calculating the difference between the audited value and the recorded balance ($490,000 – $475,200 = $14,800). See (b) above. This response would assume an audited value of $480,000, or $400 mean audited value per unit ($480,000  120 units = $400). This does not adjust the recorded amount of audited items by the $480 misstatement. The $480,000 is the audited value of the inventory, not the projected misstatement. The audited value of the inventory can be calculated as follows: The mean audited value per unit is $396 [($48,000 - $480)  120 units = $396), providing an audited value of the inventory balance of $475,200 (1,200 items x $396 = $475,200). The expected misstatement would be considered in determining the sample size for a classical variables sampling application. The overall materiality would be considered in establishing the tolerable misstatement but not directly in establishing the sample size. The risk of assessing control risk too low is related to attributes sampling but not classical variables sampling. The risk of assessing control risk too high is related to attributes sampling but not classical variables sampling. Increasing the sample size may result in the unusually large cash disbursements being selected for examination, but it is not the most efficient or effective method of doing so. Drawing multiple samples would violate some of the basic tenants of statistical sampling. Setting the tolerable misstatement at a lower level will increase the sample size but is not the most efficient or effective method of increasing the likelihood of the sample including the large disbursements. Stratifying the sample will be the most efficient and effective manner of ensuring that the unusually large disbursements are included in the audit team‘s sample.

SOLUTIONS FOR EXERCISES AND PROBLEMS FB.14

Monetary Unit Sampling (MUS) and Classical Variables Sampling a.

The advantage of MUS (disadvantage of classical variables sampling) is that because accounts receivable are assets, overstatement is the audit team‘s primary concern. MUS is more effective for overstatements than understatements because MUS automatically selects items with higher recorded balances for examination. The disadvantages of MUS (advantages of classical variables sampling) are:



Classical variables sampling is more appropriate when more than a minimal level of misstatement is expected; in this case, the moderate level of misstatement would suggest the use of classical variables sampling.



MUS is more effective when the account balance is composed of components having a relatively high level of variation (in terms of recorded dollar amounts). In this case, the relatively small amount of variation in the dollar balance in customer accounts would not make the use of MUS highly advantageous.

The advantage of MUS (disadvantage of classical variables sampling) is that the account includes a few very large balances ($500,000 of the $800,000 is concentrated in two components). MUS has a tendency to select these larger dollar items for examination. The disadvantage of MUS (advantage of classical variables sampling) is that because accounts payable are liabilities, understatement is the primary concern. MUS is more effective for overstatements, as opposed to understatements.

The advantages of MUS (disadvantages of classical variables sampling) are: 

Because accounts receivable is an asset, overstatement is the primary concern of the audit team. MUS is more effective for overstatements than understatements because it automatically selects items with higher recorded balances for examination.



MUS is more effective when the account balance is composed of components having a relatively high level of variation (in terms of recorded dollar amounts). In this particular case, components range from $1,000 to $525,000, which is significant for an account with a recorded balance of $2.5 million.

There are no apparent disadvantages of MUS (advantages of classical variables sampling) in this situation.

FB.15

Sample Size Determination: Classical Variables Sampling Each of the following examples uses the following formula for classical variables sampling [N = population size, R(IR) = Confidence factor for the risk of incorrect rejection, R(IA) = Confidence factor for the risk of incorrect acceptance, SD = Standard deviation, TE = Tolerable misstatement, EE = Expected misstatement] 2 n

N x [R(IR) + R(IA)] x SD TE – EE

2,500 x [1.96 + 1.65] x $40 [$50,000 – $20,000]

2,500 x [1.96 + 1.28] x $40 [$50,000 – $20,000]

2,500 x [1.65 + 1.28] x $40 [$50,000 – $20,000]

2,500 x [1.96 + 1.65] x $40 [$30,000 – $20,000]

2,500 x [1.96 + 1.65] x $40 [$50,000 – $10,000]

2,500 x [1.96 + 1.65] x $30 [$50,000 – $10,000]

2 =

144.80, or 145 items

116.64, or 117 items

95.39, or 96 items

1,303.21, or 1,304 items

81.45, or 82 items

45.81, or 46 items

Comparing (a) and (b), the only difference is that the risk of incorrect acceptance has increased from 5 percent to 10 percent. Because sample size decreased from 145 to 117, the risk of incorrect acceptance has an inverse relationship with sample size. Comparing (b) and (c), the only difference is that the risk of incorrect rejection has increased from 5 percent to 10 percent. Because sample size decreased from 117 to 96, the risk of incorrect rejection has an inverse relationship with sample size. Comparing (d) and (a), the only difference is that the tolerable misstatement has decreased from $50,000 to $30,000. Because sample size increased from 145 to 1,304, the tolerable misstatement has an inverse relationship with sample size. Comparing (e) and (a), the only difference is that the expected misstatement has decreased from $20,000 to $10,000. Because sample size decreased from 145 to 82, the expected misstatement has a direct relationship with sample size. Comparing (f) and (a), the only difference is that the standard deviation has decreased from $40 to $30. Because sample size decreased from 145 to 46, the standard deviation has a direct relationship with sample size.

FB.16

Sample Size Determination: Classical Variables Sampling a.

The risk of incorrect acceptance is determined using the audit risk model based on prior assessments of audit risk, risk of material misstatement, and analytical procedures risk. The risk of incorrect rejection is determined based on the cost to Solomon of expanding his sample if the initial results indicate that the account balance is materially misstated. As the costs of expanding the sample increase (decrease), Solomon would typically assess the risk of incorrect rejection at lower (higher) levels.

The advantages of establishing lower levels of the risk of incorrect acceptance and risk of incorrect rejection are that Solomon‘s sample will have a higher likelihood of representing the population. As a result, Solomon‘s sample evaluation will allow him to make the correct conclusion with respect to Warner‘s accounts receivable balance. Conversely, the disadvantage of establishing lower levels of these risks is that Solomon will be required to select and evaluate a larger sample.

Tolerable misstatement = 0.06 x $2,000,000 = $120,000 Expected misstatement = 0.04 x $2,000,000 = $80,000 2 n

N x [R(IR) + R(IA) x SD TE – EE

1,250 x [1.96 + 1.65] x $100 $120,000 – $80,000

127.26, or 128 items

2 n

1,250 x [1.65 + 1.65] x $100 $120,000 – $80,000

106.35, or 107 items

1,250 x [1.96 + 1.28] x $100 $120,000 – $80,000

102.52, or 103 items

1,250 x [1.65 + 1.28] x $100 $120,000 – $80,000

83.84, or 84 items

FB.17

Comparing the sample sizes in (c) and (d) reveals the inverse relationship between sampling risks and sample size. For example, comparing the sample size with a 5 percent risk of incorrect acceptance and incorrect rejection [(c), 128 items] with the sample size when the risk of incorrect rejection is 10 percent [(d)(1), 107 items], or the risk of incorrect acceptance is 10 percent [(d)(2), 103 items], indicates that when either sampling risk is increased, the necessary sample size decreases. As expected, when both sampling risks are increased to 10 percent, this provides Solomon the smallest sample size [(d)(3), 84 items].

Evaluating Results: Classical Variables Sampling a.

Sample estimate = Average audited value x N Sample estimate = $204 x 1,200 = $244,800

Precision = N x R(IA) x (SD  n) Precision = 1,200 x 1.65 x ($22  120) = $3.977 (rounded) Precision interval = Sample estimate  Precision Precision interval = $244,800  $3,977 = $240,823 to $248,777 The precision interval has a (1 minus risk of incorrect acceptance) probability of including the true balance of Leonard‘s inventory. In this case, there is a 95 percent (1 minus risk of incorrect acceptance of 5 percent) likelihood that Leonard‘s inventory balance is between $240,823 and $248,777.

Because the maximum difference between the recorded balance ($240,000) and the furthest boundary of the precision interval precision interval ($248,777) is less than the tolerable misstatement of $17,500, Berry would conclude that the account balance is not materially misstated.

Risk of incorrect acceptance = 1 percent Precision = N x R(IA) x (SD  n) Precision = 1,200 x 2.33 x ($22  120) = $5,615 (rounded) Precision interval = Sample estimate  Precision Precision interval = $244,800  $5,615 = $239,185 to $250,415

Risk of incorrect acceptance = 10 percent Precision = N x R(IA) x (SD  n) Precision = 1,200 x 1.28 x ($22  120) = $3,085 (rounded) Precision interval = Sample estimate  Precision Precision interval = $244,800  $3,085 = $241,715 to $247,885

FB.18

Evaluating Sample Results: Classical Variables Sampling a.

Mean-per-unit estimation: Average audited value = $900,000 ÷ 200 accounts = $4,500 Sample estimate = 2,500 accounts x $4,500 = $11,250,000

While not specifically requested by the exercise, the calculation of sample sizes under difference and ratio estimation are shown below. Difference estimation: Average difference = ($1,000,000 – $900,000) ÷ 200 accounts Average difference = $500 Estimated difference = $500 x 2,500 accounts = $1,250,000 (overstatement) Sample estimate = $3,500,000 – $1,250,000 = $2,250,000 Ratio estimation: Sample estimate = ($900,000 ÷ $1,000,000) x $3,500,000 Sample estimate = $3,150,000

These methods of estimation result in differences in the sample estimate because of differences in the size of the components of Hernandez‘s accounts receivable. For example, your sample of 200 customer accounts represents 8 percent of the components of accounts receivable (200 items ÷ 2,500 components = 8 percent); however, this sample represents a much larger percentage (28.6 percent) of the total dollars in accounts receivable ($1,000,000 ÷ $3,500,000 = 28.6 percent). The fact that this small number of accounts included such a large percentage of the dollar value of accounts receivable is the primary reason for the extraordinarily high sample estimate provided by the mean-per-unit method. This method assumes that all customer accounts in the population have the same audited value. It appears that, in this case, you did not select a sample that appropriately represents the population. Because the account balances appear to vary greatly in amount, a stratified sample would have been more appropriate. c.

In general, difference estimation and ratio estimation provide smaller sample sizes because the standard deviations of differences or ratios are typically smaller than the standard deviations of mean values. As a result, these methods are normally preferable to mean-per-unit estimation. Difference estimation and ratio estimation should be used only when a reliable measure of recorded (book) value is available because these methods rely heavily on recorded balances in determining the sample estimate. In selecting between ratio and difference estimation, you should consider whether components of the population are more likely to be misstated by similar dollar amounts (difference estimation) or similar percentages (ratio estimation). Mean-per-unit estimation is most frequently used when the population is relatively homogenous with respect to the dollar balance of the components. In addition, because both difference estimation and ratio estimation require reliable measures of recorded (book) value, mean-per-unit estimation should be used when a reliable measure of recorded balance is not available (for example, following a fraud).

Precision interval = Sample estimate ± Precision Precision interval = $3,000,000 ± $750,000 Precision interval = $2,250,000 to $3,750,000 This precision interval indicates that the range of $2,250,000 to $3,750,000 has a 95 percent probability (1 minus risk of incorrect acceptance of 5 percent) of including the true recorded balance. Tolerable misstatement in this case is $175,000. Since the recorded balance is $3,500,000, the lowest acceptable bound would be $3,325,000 ($3,500,000 - $175,000 = $3,325,000). Since the lowest bound of the precision interval is less than $3,325,000, you would conclude that Hernandez‘s accounts receivable were not fairly stated.

FB.19

Comprehensive Problem: Classical Variables Sampling 2 a.

N x [R(IR) + R(IA)] x SD TE – EE

2,000 x [1.96 + 2.33] x $30 [$32,500 – $22,500]

2,000 x [1.65 + 2.33] x $30 [$32,500 – $22,500]

2,000 x [1.65 + 1.65] x $30 [$32,500 – $22,500]

2 =

662.55, or 663 items

570.25, or 571 items

392.04, or 393 items

Howe would determine the risk of incorrect acceptance using the audit risk model and previous assessments of audit risk, risk of material misstatement, and analytical procedures risk. Howe would then determine the risk of incorrect rejection based on the costs of expanding the sample and selecting additional items. As these costs increase, the risk of incorrect rejection should be assessed at lower levels.

A comparison of (1) and (2) indicates that as the risk of incorrect rejection increases from 5 percent to 10 percent, the sample size decreases from 663 items to 571 items. Therefore, the risk of incorrect rejection has an inverse relationship with sample size. A comparison of (2) and (3), as the risk of incorrect acceptance increases from 1 percent to 5 percent, the sample size decreases from 571 items to 393 items. Therefore, the risk of incorrect acceptance has an inverse relationship with sample size.

For each of the following, the sample estimate equals $330 x 2,000 = $660,000. 1.

Precision = N x R(IA) x (SD  n) Precision = 2,000 x 2.33 x ($30  663) = $5,429 (rounded) Precision interval = Sample estimate  Precision Precision interval = $660,000  $5,429 = $654,571 to $665,429

Precision = N x R(IA) x (SD  n) Precision = 2,000 x 2.33 x ($30  571) = $5,850 (rounded) Precision interval = Sample estimate  Precision Precision interval = $660,000  $5,850 = $654,150 to $665,850

Precision = N x R(IA) x (SD  n) Precision = 2,000 x 1.65 x ($30  393) = $4,994 (rounded) Precision interval = Sample estimate  Precision Precision interval = $660,000  $4,994 = $655,006 to $664,994

Because Met‘s accounts receivable were recorded at $650,000, Howe would conclude that the accounts receivable were not misstated in all three of these scenarios. This conclusion would be made because the maximum differences between the recorded balance and the furthest boundary from the precision interval do not exceed tolerable misstatement.

FB.20 Comprehensive Problem: Classical Variables Sampling a.

Wallace would draw recorded balance of accounts receivable from Rasheed‘s year-end working trial balance. Wallace would determine the number of customer accounts by referring to a list of accounts receivable or Rasheed‘s subsidiary accounts receivable. Wallace would establish the risk of incorrect acceptance based on prior assessments of audit risk, risk of material misstatement, and analytical procedures risk. Wallace would establish the risk of incorrect rejection based on his estimate of the cost of expanding his sample (as this cost increases, he would assess the risk of incorrect rejection at lower levels). Wallace would determine the tolerable misstatement based on the recorded balance of the accounts receivable as well as key financial statement subtotals, such as sales, net income, and total assets. Wallace would base the expected misstatement on prior audits (for recurring engagements) or a pilot sample (for first-year engagements). Wallace would base the standard deviation of the mean audited value on prior audits (for recurring engagements) or a pilot sample (for first-year engagements). 2

N x [R(IR) + R(IA)] x SD TE – EE

2,000 x [1.28 + 1.65] x $52 ($50,000 – $10,000)

2 =

58.03, or 59 accounts

44.30, or 45 accounts

2 c.

N x [R(IR) + R(IA)] x SD TE – EE

2,000 x [1.28 + 1.28] x $52 ($50,000 – $10,000)

Sample size decreases from 59 accounts to 45 accounts, which is consistent with the inverse relationship between the risk of incorrect acceptance and the sample size.

Precision Precision

= =

N x R(IA) x (SD  n) 2,000 x 1.65 x ($50  59) = $21,481 (rounded)

Audited value Audited value

= =

Average audited value x Number of accounts $380 x 2,000 = $760,000

Precision interval

Audited value  Precision

Precision interval

$760,000  $21,481 = $738,519 to $781,481

Because the maximum difference between the recorded balance of $800,000 and the furthest boundary from the precision interval ($738,519) is higher than the tolerable misstatement of $50,000, Wallace would conclude that the account was materially misstated.

Audited value Audited value

= =

Average audited value x Number of accounts $405 x 2,000 = $810,000

Precision Precision

= =

N x R(IA) x (SD  n) 2,000 x 1.65 x ($50  59) = $21,481 (rounded)

Precision interval Precision interval

= =

Audited value  Precision $810,000  $21,481 = $788,519 to $831,481

Because the distance between the recorded balance of $800,000 and the furthest bound of the precision interval ($831,481) is less than the tolerable misstatement of $50,000, Wallace would conclude that Rasheed‘s accounts receivable were fairly stated. This conclusion would differ from that in (d) and (e) because the mean audited value ($405) was closer to the audited value implied by Rasheed‘s accounts receivable of $400 ($800,000  2,000 accounts = $400) than the value in (d) and (e) ($385).

FB.21

Monetary Unit and Classical Variables Sampling a. b. c. d. e. f. g. h. i. j.

Both MUS MUS Both CVS CVS Both Both Neither CVS

APPENDIX FC SOLUTIONS SOLUTIONS FOR REVIEW CHECKPOINTS FC.1

Nonstatistical sampling differs from statistical sampling in that nonstatistical methods do not explicitly control the audit team‘s acceptable exposure to sampling risk in determining sample size and evaluating sample results. Nonstatistical samples do not have to be selected by probabilistic selection techniques such as random selection or systematic selection.

FC.2

The primary factor affecting sample size in a nonstatistical sampling application is the audit team‘s professional judgment. The team would normally consider (a) the recorded balance, (b) tolerable misstatement, and (c) the risk of incorrect acceptance (through risk of material misstatement and analytical procedures risk).

SOLUTIONS FOR EXERCISES AND PROBLEMS FC.3

Evaluating Sample Results: Nonstatistical Sampling a.

Gunny may use a table (see Exhibit FA.1) or a formula that considers the recorded balance of the population, tolerable misstatement, and confidence factor that incorporates the desired risk of incorrect acceptance.

Estimated audited value

Audited value of sample Recorded balance of sample

$45,000 x $350,000 = $315,000 $50,000

Recorded balance of population

Based on the preceding information, the estimated misstatement is $35,000 (recorded balance of $350,000 minus the estimated audited value of $315,000). Because the estimated misstatement ($35,000) is more than the tolerable misstatement ($15,000), Gunny would conclude that the account balance is materially misstated.

FC.4

Nonstatistical Sampling a.

The primary advantage of Brown‘s use of nonstatistical sampling is that these methods are ordinarily easier and more efficient to use. The primary disadvantage of nonstatistical sampling is that these methods do not allow Brown to explicitly measure and control exposure to sampling risk in determining the necessary sample size and evaluating the sample results.

The factors that Brown would consider to determine the necessary sample size in MUS are:    

Tolerable misstatement. Expected misstatement. Population size (recorded account balance). Risk of incorrect acceptance.

Nonstatistical sampling uses the following factors to determine the necessary sample size:   

Tolerable misstatement. Population size (recorded account balance). Risk of incorrect acceptance (through considering risk of material misstatement and analytical procedures risk).

The differences in the factors used under MUS and nonstatistical sampling are that (1) MUS considers expected misstatement while nonstatistical sampling does not and (2) MUS explicitly considers the risk of incorrect acceptance and controls for this risk while nonstatistical sampling considers the risk of incorrect acceptance but does not explicitly control this risk at acceptable levels. c.

Assuming that analytical procedures and substantive procedures are equally effective in providing evidence as to the fairness of Longhorn‘s inventory, Brown would consider the costs associated with performing analytical procedures versus the costs of selecting and examining 11 additional inventory items (71 items – 60 items = 11 items).

Audited value

Audited value of sample Recorded balance of sample

Audited value

$970,000 $1,000,000

$6,305,000

Recorded balance of population

$6,500,000

Because the difference between the recorded balance of Longhorn‘s inventory and the audited value of this balance is $195,000 ($6,500,000 – $6,305,000 = $195,000) is less than the tolerable misstatement ($250,000), Brown might conclude that Longhorn‘s inventory is fairly stated. However, Brown must judgmentally decide how much to add to the $195,000 to control for sampling risk. She might also compare the difference to the misstatement she expected.

MODULE H Information Technology Auditing LEARNING OBJECTIVES

Review Checkpoints

Multiple Choice

Exercises, Problems and Simulations

Identify how the use of an automated transaction processing system impacts the audit examination.

1, 6

31, 34

Understand the steps that are taken to determine whether an auditor can rely on IT controls.

2, 3, 4, 5

Provide examples of general controls and understand how these controls relate to transaction processing in an accounting information system.

7, 8, 9, 10, 11

28, 30, 32, 42

44 (*), 48, 49 (*), 50, 51, 53 (*), 54 (*),

Provide examples of automated application controls and understand how these controls relate to transaction processing in an accounting information system.

12, 13, 14, 15, 16, 17

45 (*), 46 (*), 47, 49 (*), 52, 53 (*), 54 (*), 55, 56, 58 (*)

Describe how the audit team assesses control risk in an IT environment.

18, 19, 20

Identify how audit teams perform tests of controls in an IT environment.

21, 22

33, 35, 36, 37, 38, 39, 40

43, 44 (*), 45 (*), 46 (*), 58 (*)

Describe the characteristics and control issues associated with end-user and other computing environments.

23, 24, 25

Define and describe computer fraud and the controls that can be used to prevent it.

26, 27

49 (*)

(*) Item relates to multiple learning objectives

SOLUTIONS FOR REVIEW CHECKPOINTS H.1

Five major considerations introduced when the client uses automated processing are: (1) The possibility of input errors. (2) The existence of systematic rather than random processing errors. (3) The lack of a ―hard copy‖ audit trail. (4) The possibility of inappropriate access to computer files and programs. (5) The reduced level of human involvement in the processing of transactions.

H.2

The three phases that need to be conducted to determine whether an audit team can rely on IT controls are: 1) determining the scope of the IT testing plan completed by carefully identifying each of the IT dependencies; 2) understanding the IT controls and processes that need to be tested for each IT dependency; and 3) testing the IT controls.

H.3

No, the audit team is not required to gain a comprehensive understanding of the audit client's IT systems, processes and infrastructure on each audit. Rather, auditors are only required to understand the components of the IT infrastructure that have an impact on the financial reporting process. In fact, because of the potential for inefficiencies, determining the scope of the IT audit procedures to be performed is a critical step in in the audit process.

H.4

The IT dependency of a control activity refers to the extent that a key control activity is dependent on the IT system for its effective operation. For each key control activity identified by the auditor, its dependency on the IT system must be carefully determined in order to properly test its operating effectiveness.

H.5

One example of a manual control activity that is dependent on a system generated report for its effective operation would be a control activity that requires the audit client's CFO or controller to review the accounts receivable aging report to determine whether the allowance for doubtful accounts balance on the financial statements is reasonably stated. This is an example of a manual control activity (i.e., a controller review) of a system generated report (i.e., the accounts receivable aging report). Please note that in order for the control to operate effectively, the system generated aging report must be complete and accurate. As a result, the control is dependent on the IT system for its effective operation. Thus, the completeness and accuracy of the accounts receivable aging report would have to be tested as part of the IT auditing procedures. There are many other examples that would be acceptable.

H.6

The two major types of controls in an IT environment are:

H.7



General controls that apply to all applications of an automated processing system.



Automated application controls that apply to specific business activities within a automated processing system to address management assertions regarding the financial statements. The four major categories of general controls are:

(1) Program development controls: Provide reasonable assurance that (a) acquisition or development of computer programs and software is properly authorized, conducted in accordance with entity policies, and supports the entity‘s financial reporting requirements, (b) appropriate users participate in the software acquisition or program development process, (c) programs and software are tested and validated prior to being placed into operation, and (d) all software and programs have appropriate documentation. (2) Program change controls: Provide reasonable assurance that modifications to existing programs (a) are properly authorized, conducted in accordance with entity policies, and support the entity‘s financial

reporting requirements; (b) involve appropriate users in the program modification process; (c) are tested and validated prior to being placed into operation; and (d) have been appropriately documented. (3) Computer operations controls: Provide reasonable assurance that (a) the processing of transactions through the automated processing system is in accordance with the entity‘s objectives, (b) processing failures are revised on a timely basis and do not affect or unnecessarily delay the processing of other transactions within the batch, and (c) actions are taken to facilitate the backup and recovery of important data when the need arises. (4) Access to programs and data controls: Provide reasonable assurance that access to programs and data is granted only to authorized users.

H.8

The systems development life cycle (SDLC) is the process by which the entity plans, develops, and implements new automated information systems or databases. Effective SDLC controls ensure that the entity:

H.9



Follows established policies and procedures for acquiring or developing software or programs.



Involves users in the design of programs, selection of prepackaged software and programs, and testing of programs.



Tests and validates new programs and develops proper implementation and ―back out‖ plans prior to placing the programs into operation.



Periodically reviews policies and procedures for acquiring and developing software or programs for continued appropriateness and modifying these policies and procedures as necessary.

The primary duties associated with various functions related to accounting information systems are: 

Systems analyst: Examines requirements for information, evaluates the existing system, and designs new or improved accounting information systems (along with the program specifications and documentation).



Programmer: Flowcharts the logic of the computer programs required by the automated processing system designed by the systems analyst.



Computer operator: Operates the computer for each accounting application system according to written operating procedures found in the computer operation instructions.



Data conversion operator: Prepares data for machine processing by converting manual data into machine-readable form or directly entering transactions into the system using remote terminals.



Librarian: Maintains control over (1) system and program documentation and (2) data files and programs used in processing transactions.



Control group: Ensures the integrity of data, the accuracy of processing and output, and the controls distribution of output to appropriate user groups.

Separation of the duties performed by systems analysts, programmers, and computer operators is important. The general idea is that anyone who designs a automated processing system should not perform the technical programming work, and anyone who performs either of these tasks should not be the computer operator when data are processed. Persons performing each function should not have access to each other‘s work, and only the computer operators should have access to the equipment. H.10

Controls related to the use of files and data include: 1-600 Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.



The use of external labels on portable files and header and trailer labels on internal records to ensure that appropriate files are used in computer processing.



Storage of files in fireproof and waterproof locations and periodic backups maintained in remote (off-site) locations.



Using processes (such as grandfather-father-son) to reconstruct files from earlier versions of information used in processing.

H.11

General controls are important in the audit team‘s evaluation of internal control and assessment of control risk (and the risk of material misstatement) because they are pervasive, and the effectiveness of automated application controls relies heavily on the effectiveness of general controls.

H.12

The objective of input controls is to provide reasonable assurance that data received for processing by the computer department has been properly authorized and accurately entered and converted for processing.

H.13

Data entry and formatting controls minimize the likelihood of input errors by (a) allowing users to select from a limited number of alternative choices rather than inputting data, (b) increasing user familiarity with various fields and reducing the likelihood that data is inadvertently input in an incorrect field, and (c) allowing users to review input prior to submitting data for processing within the system.

H.14

Record counts are tallies of the number of transaction documents submitted for data conversion. These counts allow the identification of situations in which transactions may not have been input or may have been input more than once. Batch totals are mathematical totals of an important and numerically meaningful quantity or amount, such as the total of sales dollars in a batch of invoices. Batch totals allow the following types of input errors to be detected: (a) input error for the wrong amount, (b) transactions have not been input, and (c) transactions have been input more than once. Hash totals are mathematical totals of a quantity or amount that is not meaningful, such as the total of all invoice numbers. Like batch totals, hash totals allow the following types of input errors to be detected: (a) input error for the wrong amount, (b) transactions have not been input, and (c) transactions have been input more than once.

H.15

Input controls affect the accuracy, completeness, and occurrence assertions.

H.16

The objective of processing controls is to provide reasonable assurance that data processing has been performed accurately, without any omission or duplication of transactions. Examples of processing controls include: 

Periodically testing and evaluating the processing accuracy of computer programs.



File and operator controls: These controls include (a) the use of external and internal labels to identify files and (b) the review of a log by supervisory personnel related to the use of specific computer applications.



Run-to-run totals: Totals such as record counts, batch totals, and/or hash totals obtained at the end of one processing run are distributed to the next run and compared to corresponding totals produced at the end of the second run.



Control total reports: Control totals, such as record counts, batch totals, hash totals, and run-torun totals, can be calculated during processing and reconciled to input totals or totals from earlier processing runs.

H.17



Limit and reasonableness tests: These tests should be programmed to ensure that illogical conditions do not occur (for example, depreciating an asset below zero or calculating a negative inventory quantity).



Error correction and resubmission procedures: Ensure identification of input errors on a timely basis and correction and resubmission by appropriate personnel for processing.

The objective of output controls is to ensure that only authorized persons receive output or have access to files produced by the system. Some common output controls include: 

Review of output for reasonableness: Reviews the computer output to ensure that no ―obvious‖ or systematic errors have occurred in processing.



Control total reports: Compare controls totals to input and run-to-run control totals produced during transaction processing.



Master file changes: Any changes to master file information should be properly authorized by the entity and reported in detail to the user department from which the request for change originated.



Output distribution: Systems output should be distributed only to persons authorized to receive the output.

H.18

The audit team‘s objective in obtaining on overall understanding of internal control in an IT environment is to become aware of the type of controls that have been implemented by the client for the automated processing of transactions.

H.19

The major steps in the audit team‘s assessment of control risk in an IT environment include:

H.20



Identify specific control objectives based on the types of misstatements that can occur in significant accounting applications.



Identify the points in the flow of transactions where specific types of misstatements could occur.



Identify specific control procedures designed to prevent or detect these misstatements.



Evaluate the design of control procedures to determine whether the design suggests a low control risk and whether tests of controls might be cost effective.

The following are points in the processing of transactions at which misstatements may be introduced in an IT environment:      

H.21

Preparing and converting data to machine-readable form. Accessing files and programs during computer processing. Transferring data between computer programs and applications. Updating master file information following processing. Processing transactions by computer programs. Correcting and resubmitting errors at input or during processing.

The test data technique uses simulated transactions created by audit teams that are processed by the client‘s actual programs at a different time than the processing of actual client transactions.

H.22

Four methods used by audit teams to test the operating effectiveness of controls are inquiry, observation, document examination, and reperformance.

H.23

In an end-user environment, limited resources may result in a lack of separation of duties in the accounting function (initiate and authorize source documents, enter data, operate the computer, and distribute output) and computer functions (programming and computer operations).

H.24

Major control issues in end-user computing environments include:    

H.25

Lack of separation of duties, both in accounting functions and computer functions. Lack of physical security over computer hardware, programs, and data files. Lack of program documentation and testing. Limited computer knowledge.

Control procedures an entity can use to achieve control over computer operations in an end-user computing environment include:     

Joint operation by two or more individuals. Rotation of assigned duties among individuals. Comparisons of computer use time to averages or norms and investigation of excess usage. Proper supervision of computer operations. Required vacations for all individuals.

Control procedures an entity can use to achieve control over automated processing in an end-user computing environment include:     H.26

Transaction logs. Control totals. Data comparisons. Audit trail provided by transactions logs and periodic dumps of master files.

Physical controls that can be used to protect accounting information systems from fraud include:      

Inconspicuous location. Controlled access. After-hours computer room guard. Computer room entry log record. Preprinted limits on documents. Data backup storage.

Technical controls that can be used to protect accounting information systems from fraud include:       

Data encryption. Access control software and passwords. Transaction logging reports. Control totals (both batch totals and hash totals). Program source comparison. Range checks on permitted transaction amounts. Reasonableness check on permitted transaction amounts.

Administrative controls that can be used to protect accounting information systems from fraud include:  

Security checks on personnel. Separation of duties.

    H.27

Proper review of access and execution log records. Program testing after modification. Rotation of computer duties. Transaction limit amounts.

Computer forensics is the science of acquiring, preserving, retrieving, and presenting data that have been processed electronically and stored on computer media. Computer forensics can be used in fraud investigations by retrieving data that had been previously erased from various storage devices.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS H.28

H.29

H.30

H.31

H.32

Incorrect

Correct

b. c. d.

Incorrect Incorrect Incorrect

Incorrect

Correct

Incorrect

c. d.

Incorrect Correct

a. b.

Incorrect Incorrect

Incorrect

Correct

Automated controls work best when there is a high volume of recurring transactions. Automated controls work best when there is a high volume of recurring transactions. Automated controls work best when there is a high volume of recurring transactions. Automated controls work best when there is a high volume of recurring transactions. A payroll processing program is an example of user software that would contain automated application controls related to payroll processing. The operating system program is an example of a system program. Data management system software is an example of a system program. A utility program is an example of system programs. The computer librarian is the appropriate person to maintain these files because this individual has no access to the computer. Computer operators should not have access to instructions and detailed program lists because they have would have enough knowledge to alter programs and run those programs. The control group is appropriate for distributing output because the group does not have access to programs and computer. Computer programmers are the appropriate individuals to write and debug programs because they have no access to data. The skill level of employees in an IT environment is not necessarily related to the incidence of fraud. Due to the limitations of computer evidence (which may exist for only a very brief time), audit teams should audit the automated processing system throughout the year. High dollar amounts are not unique to an IT environment. Because of the accessibility to a large number of computer terminals, employees have greater access to accounting information systems and computer resources in an IT environment. Control totals detect input and processing errors. Record counts are used to ensure that all transactions are entered once and only once. Limit checks identify items that are larger than expected during input or processing. External labels reduce the likelihood that operators will use an incorrect file.

H.33

H.34

H.35

H.36

H.37

H.38

H.39

H.40

Correct

b. c. d.

Incorrect Incorrect Incorrect

a. b.

Incorrect Correct

Incorrect

a. b.

Incorrect Incorrect

Correct

Incorrect

b. c.

Incorrect Incorrect

Correct

Incorrect

b. c.

Incorrect Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

a. b.

Incorrect Correct

Incorrect

Correct

When it is not possible to reduce detection risk solely by using substantive tests of transactions, an auditor would most likely rely on a client‘s internal controls. Increasing the sample size does not reduce detection risk. An auditor would not adjust materiality in this circumstance. Use of analytical procedures does not have an effect on control risk.

Condensing data would not necessarily result in a more efficient audit. Abnormal conditions inform audit teams of potential issues and allow them to focus their efforts on these issues. Decreases in tests of controls would depend upon the content of the exemption reports (i.e., number of exceptions), not the existence of these reports. Exception reporting is an example of an output control, not an input control. The use of test data evaluates IT controls, not input data. Machine capacity can be evaluated by reference to the manufacturer‘s specifications. Test data are used to examine the operating effectiveness of IT control procedures. Test data provide evidence on specific application control procedures, not on general controls. The speed and efficiency of the computer would enable more transactions to be evaluated, not fewer. The risk of misstatement is not necessarily lower in an IT environment. The extent of substantive testing is not necessarily higher in an IT an IT environment. In an IT environment, a sample of one transaction is sufficient because the computer handles all transactions identically. Writing a computer program that simulates the logic of an effective password control system does not test the actual system. A test of proper authorization is not a test of actual access to the system. Attempting to sign on to the computer system with a false password is similar to a test data approach. Several different types of false passwords might need to be used. Written representations are not a direct or reliable form of evidence on a detailed matter such as password controls. Inquiries produce a relatively weak form of evidence. Observation is not relevant to the existence of processing controls. This method will test processing controls because it compares known input with computer output. The run manual provides information to the computer operator but does not allow audit teams to evaluate processing controls. Computers do not make mathematical errors. The use of portable computing devices makes it is easier for unauthorized persons to access the computer and alter data files. Transaction coding prior to automated processing represents a control consideration. The rarity of random errors in report printing represents a control consideration. Check digits are imbedded algorithms that prevent incorrect characters from being input.

H.41

H.42

Incorrect

c. d.

Incorrect Incorrect

Incorrect

Correct

Incorrect

a. b. c.

Incorrect Incorrect Correct

Incorrect

Record counts involve totaling the number of items input. In this case, the correct number of transactions would be input, so a record count would not detect the error Hash totals involve a number of transactions, not single transactions. A redundant data check is a hardware control to make sure that computers properly communicate with each other. Sequence checking tests the input data for numerical sequence of documents when sequence is important for processing as in batch processing. This control does little to address completeness and transaction accuracy. Batch totals sum dollar amounts of items that have numerical significance (such as inventory data). These totals address the completeness and accuracy of data input. Limit checks are input controls that prevent numbers outside a specified range from being incorrectly input. These controls might address accuracy but not completeness. Check digits are imbedded algorithms that prevent incorrect characters from being input but provide little assurance regarding the completeness of the data. Programmers code the logic in the computer program. Data conversion operators prepare data for automated processing. Librarians control access to systems documentation and access to programs and data files. Computer operators operate the computer for each application according to written operating procedures found in the computer operation instructions.

SOLUTIONS FOR EXERCISES, PROBLEMS AND SIMULATIONS H.43

Auditing Automated Controls a.

The primary sources of error that could occur include (1) incorrectly inputting data into machinereadable form, (2) errors in calculating various payroll data, (3) accessing incorrect data from employee master files, and (4) accessing incorrect data from standard deduction tables.

If auditing through the computer, you would evaluate input controls to ensure that:  Employees can be identified only as hourly (H) or salaried (S).  Only valid employee numbers can be entered for data processing.  Hours worked cannot exceed some reasonable limit. In addition to input controls, the other controls you would evaluate relate to the accuracy of automated processing for one hourly employee and one salaried employee. One method of doing so is by manually calculating the results and comparing that calculation to the automated processing.

H.44

Tests of Controls: General Controls

Note to instructor regarding problems H.41–H.43: The following are examples of how each method could be used by the audit team to test the operating effectiveness of the identified computer controls. The method(s) selected by the audit team would be influenced by the desired effectiveness of the tests (for example, reperformance is generally the most effective method). In addition, the audit team‘s ability to use observation would depend on the timing of the test, particularly for controls that are applied less frequently. Control 1. Packer has routine maintenance on its computer equipment and related technology scheduled and performed every six months 2. Packer has formal, written systems development and documentation standards for the implementation of new programs 3. Prior to implementing modifications to its existing programs, Packer tests and validates the program changes to ensure accurate processing

Inquiry Inquire of client personnel regarding maintenance schedule

Observation Observe maintenance being performed on scheduled date(s)

Document Examination Examine documentary evidence related to maintenance, such as vendor invoices or work orders

Reperformance Not applicable

Inquire as to existence of systems development and documentation standards Inquire as to requirements for testing and validating program changes

Not applicable

Examine written systems development and documentation standards

Not applicable

Observe client personnel testing and validating program changes

Examine written documentary evidence that program changes have been tested and validated

4. Packer has appropriately separated the responsibilities of systems analysts, programmers, and computer operators 5. Packer‘s computer files are protected from loss through frequent backups and storage at an off-site location 6. Access to computer files and programs is protected through the use of passwords

Inquire as to separation of duties

Observe separation of duties

Not applicable

Generally not applicable because program changes would normally be infrequent; however, the audit team could process sample transactions to test program changes Not applicable

Inquire as to backup and off-site storage of files

Observe backup and off-site storage of files

Examine documentary evidence regarding backup and off-site storage of files

Not applicable

Inquire as to the use of passwords for accessing programs and files

Observe client personnel using passwords as they attempt to access programs and files

Not applicable

Audit team attempts to access programs and files using invalid passwords to ensure that access is denied

7. On a monthly basis, Packer reviews any revisions in the access rights of its employees to ensure consistency between their new job responsibilities and files and programs they may access

Inquire as to periodic review and authorization of revisions to employee access rights

Observe client employees reviewing and authorizing revisions to employee access rights

Examine documentary evidence that revisions to employee access rights have been reviewed and authorized by client personnel

Audit team selects a sample of revisions to employee access rights and verifies changes in employee job responsibilities or other form of documentary evidence

H.45

Note to instructor: See introduction to H.44. Control

Inquiry

Observation

1. Data entry personnel must enter a valid password to access the data entry program

Inquire as to the required use of passwords to access data entry program

Observe client data entry personnel using passwords to access data entry program

2. A check digit is appended to the customer number as a seventh digit

Inquire as to use of check digits with customer numbers

Generally not applicable because check digits are electronically created and cannot be physically observed (could observe the entry of 7-digit customer numbers)

3. The following control totals are manually determined prior to input and then compared to a total generated by the computer program: (a) number of records entered, (b) sum of customer numbers, and (c) sum of quantities. 4. The program rejects a customer number or inventory quantity containing an alphabetic character and any entry for item numbers having an inappropriate character in a given field. Data entry personnel are prompted to reenter the information upon rejection of the original entry

Inquire as to use of control totals and comparison to computer-generated totals

Observe client personnel use of control totals and comparison to computer-generated totals

Inquire as to operating effectiveness of controls for inappropriate format

Generally not applicable because entries with an inappropriate format would randomly occur and be corrected immediately following entry, making observation impractical

Document Examination Not applicable

Generally not applicable because check digits are electronically created and are not formally documented (could examine documentary evidence that indicates 7-digit customer numbers are used) Examine documentary evidence related to the use of control totals and comparison to computer-generated totals

Generally not applicable because entries with an inappropriate format would randomly occur and be corrected immediately following entry, and would not be formally documented

Reperformance Audit team attempts to access data entry program using invalid passwords to ensure that access is denied Audit team attempts to enter customer numbers with invalid or missing check digits to ensure that transaction is rejected

For a sample of transactions, audit team calculates control totals and compares these totals to computergenerated totals

Audit team attempts to enter data with inappropriate format to ensure that transaction is rejected (this would not ensure that client personnel re-enter information)

H.45

Tests of Controls: Input Controls (Continued)

Control

Inquiry

Observation

5. Any quantities ordered in excess of 9,999 are highly unusual and require special authorization by Knight‘s management. Any such entries are rejected and written to a rejected order file for follow-up and authorization

Inquire as to operating effectiveness of controls for quantities in excess of 9,999

Generally not applicable because entries with quantities in excess of 9,999 would randomly occur, making observation impractical

Inquire as to the operating effectiveness of controls for rejecting invalid customer numbers

Generally not applicable because entries with invalid customer numbers would randomly occur, making observation impractical

Document Examination Examine documentary evidence for transactions that represent quantities in excess of 9,999 to ensure that the transactions are written to a rejected order file

Reperformance

Examine documentary evidence related to identification of invalid customer numbers

Attempts by audit team to enter transactions with invalid customer numbers to verify that they are rejected and identified for follow-up

Attempts by audit team to enter transactions with quantities in excess of 9,999 to verify that they are written to a rejected order file

NOTE: The accompanying tests would evaluate the rejection of entries, not follow-up of rejected entries 6. NOTE: The following would test rejection of entries, not follow-up of entries. If an order is received from a customer whose number is not in the customer master file (either a new customer or an erroneous entry for an existing customer), the transaction is rejected and written to a rejected order file; depending on the reason for the invalid customer number, a credit check is conducted (if an order from a new customer) or the entry is corrected (if an erroneous entry of the customer number)

H.46

Tests of Controls: Processing and Output Controls

Note to instructor: See introduction to H.44. Control

Inquiry

Observation

Document Examination Examine documentary evidence supporting weekly generation and review of system log

Reperformance

1. To detect unauthorized access to payroll programs and processing, a system log is generated and reviewed on a weekly basis; this log identifies the programs that have been accessed during the past week, the individual(s) that have accessed those programs, and the time(s) during which the programs have been accessed. This log is reviewed and any unexpected or unauthorized access is investigated immediately 2. Control totals are determined prior to the input of data and compared to computergenerated totals following transaction processing

Inquire of client personnel who generate and review the system log

Observe generation and review of system log by appropriate personnel

Inquire as to use of control totals and comparison to computer-generated totals

Observe client personnel use of control totals and comparison to computer-generated totals

Examine documentary evidence related to the use of control totals and comparison to computer-generated totals

Not applicable (can observe the investigation, but not the operation of the control and identification of transactions)

Examine documentary evidence for payroll transactions in excess of $25,000 per month to verify that these transactions are written to a separate file for investigation

For a sample of transactions, audit team calculates control totals and compares to computer-generated totals following transaction processing Audit team prepares transactions in excess of $25,000 per month and ensures that these are written to a separate file for investigation

3. Any gross pay calculations in excess of $25,000 per month are identified and written to a rejected transaction file for separate investigation because Mark‘s highest paid employee whose salary is process through the system earns $300,000 per year

Inquire as to operating effectiveness of controls to identify gross pay calculations in excess of $25,000 per month

Audit team reviews system log and compares logged access to a list of authorized users

4. The system generates a report of any errors or unusual situations identified during transaction processing; this report is reviewed and any items are resolved in a timely manner, and the resolution is documented by notations on the report

Inquire as to the generation of the report and timely resolution of error conditions and unusual situations

Not applicable (can observe the resolution, but not the operation of the control and identification of transactions)

Examine documentary evidence related to system-generated report and timely resolution of error conditions and unusual situations

Not applicable

5. Any changes to employee master file information since the last payroll period are evaluated to ensure that they have been properly authorized by the appropriate personnel.

Inquire as to authorization of changes to employee master file information

Observe client personnel authorizing changes to employee master file information

Examine documentary evidence of authorization of changes to employee master file information

Audit team identifies a sample of changes to employee master file information and vouches to some form of authorization for the change

6. The output is reviewed for reasonableness prior to distribution to users.

Inquire as to review of output for reasonableness

Observe client personnel reviewing output for reasonableness

Examine documentary evidence related to review of output for reasonableness

Audit team reviews output for reasonableness

H.47

Computer Internal Control Questionnaire Evaluation Does access to online files require specific passwords to be entered to identify and validate the terminal user? Unauthorized access may be obtained to programs or data resulting in the loss of assets or other entity resources through theft or fraud. Does the user establish control totals prior to submitting data for processing? Sales transactions may be lost in data conversion or processing or errors made in data conversion or processing. Are input totals reconciled to output control totals? Control totals are not useful unless they are reconciled to equivalent totals determined following processing. As a result, audit teams would fail to detect errors made in the input or processing of data.

H.48

Separation of Duties and General Control Procedures a.

The primary internal control objectives in separating the programming and operating functions are achieved by (1) preventing operator access to the computer or to input or output documents, (2) preventing operator access to operating programs and operating program documentation, and (3) preventing operators from developing or modifying programs. Programmers should not be allowed in the computer room during processing. They should submit their tests to be scheduled and run by the operators just like any other job. Operators should not be allowed to interfere with the running of any program. If an application fails, the operators should not be allowed to attempt to fix the programs. The failed application should be returned to the programmers for correction.

In a small computer installation where there are few employees, separation of the programming and operating functions may not be possible (as in an end-user computing environment). Important compensating controls for the lack of separation of duties include:       

H.49

Comparison of manual control totals with totals from computer output. Careful inspection of output for accuracy. Joint operation by two or more operators. Rotation of assigned duties among individuals. Comparison of computer use time to averages or norms and investigation of excess usage. Proper supervision of all computer operations. Required vacations for all employees.

Computer Frauds and Missing Control Procedures a.

Identify the type of input controls that should exist in this environment.    

Authorization and data entry (record-keeping) functions appropriately separated. Receipt (receiving report) matched or independently coded. There is an approved master file of authorized vendors for matching payees to authorized vendors. There are range checks or limit or reasonableness tests if the check amounts were large (average of $31,000 in the entity).

In developing test data to evaluate the operating effectiveness of the client‘s automated controls, the auditor should have incorporated these error conditions into the test data:  

Separation of employee accounts from investors‘ accounts for control group review of activity. Failure to log employee-investor transfer transactions that would detect this type of manipulation.

In this case, password access controls were not established or operating properly.

In this case, the time in the system was not checked against the actual time.

H.50

General Controls The benefit of each of the following examples of general controls follows: a. b. c. d. e. f. g. h.

H.51

Data cannot be altered or modified as they are transmitted within the system. Hardware will be reliable and function as intended in processing transactions. Programs and software will meet users‘ needs. Programs will properly process transactions. All ―emergency‖ changes to programs are properly approved by the entity. Computer programs used in processing transactions do not (1) incorrectly process transactions or (2) misappropriate or otherwise expose assets to loss. Data and files are protected from loss. Employees may access only appropriate files and data.

General Controls

Control Category Access to programs and data

Objective To ensure that only authorized individuals have the ability to access the entity‘s computer files and programs

Program change

Computer operations

Program change

To ensure that all ―emergency‖ change requests are properly authorized by the entity and consistent with the entity‘s objectives To ensure that the entity is protected from losses or destruction of files To ensure that the programs and prepackaged software will meet the entity‘s users‘ needs

Computer operations

To ensure that significant delays in processing transactions will not occur

Program development

To ensure that programs developed by the entity will meet its processing needs

Program change

Computer operations

To ensure that individuals within the entity can identify the reasons for modifications and all modifications are done for legitimate purposes To ensure that individuals within the entity are not in position to engage in a fraudulent defalcation scheme

Access to programs and data

To ensure that programs are not being accessed by unauthorized individuals and users

Test of Control Example Attempt to ―log in‖ using a fictitious password Verify (through inquiry or documentary evidence) that passwords are modified every three months Inspect documentary evidence showing authorization of ―emergency‖ change requests

Inspect the backup and storage of files in safe, off-site locations Inquire of the entity‘s management or inspect documentary evidence that users are involved in the design of programs and selection of prepackaged software Inspect documentary evidence of the resolution of processing errors, paying particular attention to the timeliness of the resolution Inspect documentary evidence that the entity‘s needs and objectives were considered in the program development process Inspect documentary evidence that program modifications are properly documented

Inquire as to the separation of duties or, through direct observation, verify that incompatible functions are not being performed by certain individual(s) Inspect documentary evidence of comparisons between the user list and record of user access

H.52

Automated Application Controls: Input Controls Note to instructor: The following is one possible response for each control. Others are possible, depending on the data item selected by the student. a.

Brady could develop pull-down screens (for entity division) and standardized formats and screens to increase its employees‘ familiarity with the various fields. Because the types of data input are relatively different in terms of number of characters and format, it is not likely that Brady‘s employees would input data in an inappropriate field.

A check digit can be calculated and appended to the employee number to ensure accurate input of the employee number. Check digits are most appropriate for this data item because it is entirely numeric (unlike the entity division) and will remain constant over time (unlike the number of hours worked).

Brady can count the total number of employee attendance records submitted and compare it to the total number of records entered into the automated transaction processing system.

The total hours worked can be determined prior to input and compared to the total entered into the automated transaction processing system.

The total of the employee numbers can be determined prior to input and compared to the total entered into the automated transaction processing system (the entity division is an alphanumeric field, so a hash total on this field would not be possible).

Controls can be implemented to ensure that only numeric information is entered for employee numbers and hours worked while permitting alphabetic entries in the first two fields of the entity division and numeric entries in the last three fields of the entity division.

Controls can be implemented to ensure that negative entries are not permitted for employee number, entity division, and hours worked.

Controls can be implemented to identify entries for a high number of hours worked (for example, more than 100 hours per week). Limit or reasonableness tests would generally not be appropriate for either employee number or entity division.

Controls should allow personnel to correct any errors identified by the input controls noted in (a) through (h) and promptly resubmit the transaction for processing.

H.53

Identify IT Control Weaknesses a. Weaknesses

Recommendations

Lack of separation of duties

Computer operations, program changes, and maintenance of computer logs should be performed by different people

Librarian function does not exist

Custody and control over databases and system documentation should be under a librarian function, not rotated among computer operators

Computer programmers have access to computer room

Modify procedures to restrict access to the computer room to computer operators only

Deficient documentation

Documentation of flowcharts, program changes, systems programs, and testing should be required

No computer price list

For manual entry process, clerk should not need to manually enter the sales price. This information should be accessed from a computer file.

Failure to use control totals and processing controls

Implement control totals and processing controls as appropriate

Numerical sequence of shipping notices is manually checked by the billing clerk

The computer should be used to check numerical sequence of shipping notices

Control totals determined by the billing clerk do not appear to be used appropriately.

The billing clerk‘s control total of sales should be used to compare to total sales processed by the computer

Open invoice file serves as a detail accounts receivable record.

The accounting information system should be programmed to maintain customer accounts receivable records

Ajax‘s automated processing over shipping and billing could be improved by having shipping clerks enter the date, customer identification number, shipment quantities, and product identification numbers in a terminal. Then the computer system could automatically produce a sales invoice. Controls include:      

Automatic date checking. Check digits for customer identification numbers and product identification numbers. Hash total of customer identification numbers. Automatic numbering of sales invoices. Use of authorized price list through reference to computer files. Control total comparison of hash totals of identification numbers in run-to-run totals.

H.54

Identify Control Weaknesses and Recommendations Weakness

Recommended Improvements

Computer department functions have not been appropriately separated because the same employee completely controls programming and operations.

The functions of systems analysis and design programming and computer operations should be separated.

Records of computer operations have not been maintained.

To properly control the use of the computer, a usage log should be kept and reconciled by the supervisor.

Physical control over computer operations is not adequate. All computer department employees have access to the computer.

Only operating employees should have access to the computer room. Programmers‘ usage should be limited to program testing and debugging.

System operations have not been adequately documented. No record has been kept of adaptations made by the programmer or new programs.

The entity should maintain current system and program flowcharts, record layouts, program lists, and operator instructions. All changes in the system should be documented.

Physical control over files and system documentation is not adequate. Materials are unguarded and readily available in the computer department.

Programs and file libraries should be carefully controlled in a separate location, preferably by a librarian who does not have access to the computer.

The entity has not used IT controls. Some of the procedures and controls used in the tabulating system may be unnecessary or ineffective in the automated transaction processing system.

IT controls should be used to supplement existing manual controls, and an independent review should be made of manual controls and tabulating system procedures to determine their applicability. Examples of IT controls that might be programmed include data reliability tests, check digits, limit and reasonableness tests, sequence checks and error routines for unmatched items, erroneous data, and violations of limits.

Manual insertion of prices on shipping notices by the billing clerk is inefficient and subject to error.

The entity‘s price list should be included in a master file and matched with product numbers on the shipping notices to obtain appropriate prices.

Manual checking of the numerical sequence of shipping notices by the billing clerk is inefficient and subject to error.

The computer should be programmed to check the numerical sequence of shipping notices and provide a report with any missing number(s).

Control over computer input is not effective. The computer operator has been given responsibility for checking agreement of output with the daily summaries. This is not an independent check.

The billing clerk (or another designated control clerk) should retain the daily summaries and check them against the daily sales register. This independent check should be supplemented by programming the computer to check control totals and print error messages when appropriate.

H.54

Identify Control Weaknesses and Recommendations (Continued)

Weakness

Recommended Improvement

The billing clerk should not maintain accounts receivable detail records.

a. If receivable records are to be maintained manually, a receivable clerk who is independent of billing and cash collections should be designated. If the records are updated by the computer department, as recommended as follows, there still should be an independent check by the general accounting department.

Accounts receivable records are maintained manually in an open invoice file.

b. These records could be maintained more efficiently in a computer file.

The billing clerk should not receive or mail invoices.

c. The computer department should forward copies of invoices to the customer (or to the mailroom) and distribute them to other recipients in accordance with established procedures.

m. Maintaining a chronological file of invoices appears to be unnecessary.

d. Discontinue practice of maintaining a chronological file of invoices. This file‘s purpose may be fulfilled by the daily sales register.

e. The computer can be programmed to print a daily list of invoices applicable to individual warehouses. This will eliminate the sorting of invoices.

Sending duplicate copies of invoices to the warehouse is inefficient.

H.55

Automated Application Controls 1.

The use of a login protocol appears to be an effective control because the beginning and ending times of an employee‘s workday cannot be altered or manipulated by that employee. As with any process of this type, the possibility exists that employees may log in, leave the premises, and return to log out at a later time without actually performing work responsibilities. However, this behavior would undoubtedly be identified by that employee‘s supervisor at some later time.

Requiring Merriman‘s employees to approve their own attendance records prior to submission allows unusual situations to be identified (for example, an employee forgetting to log in or log out on a particular workday). Authorization of these records also provides the entity appropriate evidence of intent when employees attempt to engage in fraudulent activities with respect to submitting false attendance information because employees cannot indicate that they were unaware of the hours they submitted.

Supervisory approval is an effective control because it serves as the first line of defense in detecting fraudulent employee activities with respect to attendance information. This control may be effective for Merriman in identifying situations when a terminated employee has not been removed from the payroll. Finally, it may identify situations in which salaried employees are not working the proper number of hours.

In data conversion, a number of input controls such as the following should be considered: 

The use of data entry and formatting controls, such as pull-down menus and standardized screens.



A check digit can be calculated for each employee number and appended to that number.



Record counts of the number of employee records can be made prior to input and compared to totals generated by the computer program following data conversion.



Batch totals (using number of hours worked) and hash totals (using attendance record numbers and employee numbers) can be calculated prior to input and compared to totals generated by the computer program following data conversion.



Valid character tests can reject any entry that includes an alphabetic character (assuming that the reference number and employee number are comprised exclusively of numeric characters).



Valid sign tests will ensure that no negative amounts are entered for hours worked.



Missing data tests can reject any entry that does not include both the employee number and the number of hours worked.



Sequence tests can identify any missing payroll attendance records.



Limit or reasonableness tests can be used to identify any hours worked that exceed some reasonable threshold (for example, more than 150 hours in any two-week payroll period).

H.55

Automated Application Controls (Continued)

Prior to processing, it is important that any errors in data conversion that could be detected by the input controls noted in (4) are corrected and resubmitted prior to processing. This correction should allow any data conversion errors to be resolved in a timely fashion and not unnecessarily delay the processing of other employee records within the batch. At this point, the following processing controls could be considered: 

Merriman should periodically test and evaluate the processing accuracy of its computer programs.



Control total reports could be generated and summarized for attendance record numbers (hash total), employee numbers (hash total), and hours worked (batch total).



The number of records processed can be identified and compared to the number of attendance reports submitted (record count).



Limit and reasonableness tests can be used to identify processing errors (for example, identifying any employee with a biweekly gross pay in excess of $500,000 or less than $500).



Error correction and resubmission procedures can be used to identify processing errors and correct and resubmit transactions for processing; this is similar to the use in (4), but would be performed after data are accepted for input.

One additional issue relates to the hours worked by salaried employees. A limit or reasonableness test could identify situations in which salaried employees are not working sufficient hours to justify their level of compensation. This test could identify situations in which the hours worked by salaried employees are less than some predetermined threshold (for example, 20 hours per week). Finally, Merriman could modify its system to eliminate the data conversion process in (4) and use the computer records submitted by employees without the intermediate step of data conversion. If so, run-to-run totals could be used to provide reasonable assurance that all records have been received for processing and no records were processed more than once. 6.

The calculation of deductions is, in some sense, an extension of the calculation of gross pay. Assuming that the controls in (5) are implemented, similar controls would be effective in determining deductions and net pay (particularly limit and reasonableness tests). Other controls related to this step include: 

The use of standardized income tax and FICA withholding tables provides reasonable assurance that these deductions are accurately determined using the employees‘ withholding information.



The use of file labels (either internal or external) provides reasonable assurance that the most recent version of the payroll master file was used in calculating deductions. Employee withholding information (number of exemptions, contribution levels to 401(k) plans, etc.) is likely to change more frequently than their pay information (wage rate or salary), making this control particularly important for withholdings.

H.55

Automated Application Controls (Continued)

H.56

Review of the payroll register provides reasonable assurance that ―obvious‖ processing errors (extraordinarily high or low levels of gross pay, deductions, or net pay) are identified. Other controls that Merriman could consider are: 

The data control group should reconcile control totals calculated through processing to the corresponding totals that are produced as output by the data control group.



Any changes to the employees‘ master file records should be reported to the requesting department.



The distribution of the payroll register should be limited to specific individuals.

For funds electronically transferred, Merriman should periodically verify appropriate account information for employees and that Merriman still employs the designated employees. For paychecks, Merriman should keep these in a safe place under the control of individuals who are otherwise not involved in the processing of payroll transactions. In addition, Merriman should verify that it still employs the employees and request proper identification prior to distributing paychecks to them.

Flowchart Control Points 1.

Control over issuance and retirement of badges.

Control totals developed from input card punch operation with comparison to detailed records to ensure that all cards are processed accurately.

Control over authority for master file changes and over custody of the master file.

Controls to ensure the resolution of exceptions by the foreperson (e.g., review procedures or a surprise audit, if necessary.)

Control over authority to issue special and indirect labor charges to maintain integrity of cost accounting system.

Control totals developed for input job transaction cards and output error list to ensure that all cards are processed and reprocessed accurately. Controls to ensure that all rejected and erroneous transactions are cleared promptly (e.g., review procedures and a surprise audit, if necessary).

H.57

Internal Control Considerations in an End-User Computing Environments a.

Potential internal control weaknesses

Although the addition of personal computers may well prove beneficial to Chicago Appliance, a number of apparent internal control weaknesses exist that could have serious ramifications. (1) The files are stored near the computer, and employees are ―encouraged‖ to experiment with the computer. Thus, many employees appear to have access to the accounts receivable and fixed asset files. Such access could result in improper alteration to the related data or programs. (2) The accounts receivable program was partially reprogrammed by the controller and thus appears easily susceptible to change. Tampering with an actual (―live‖) program could result in the improper processing of data. (3) The accounts receivable program does not leave an audit trail. Account balances are updated, but no transaction record of the individual billings and payments is made (only invoice or check amounts are entered into the system, not invoice numbers, dates, etc.). As a result, it would be very time consuming to investigate any differences that might arise between the accounts receivable detail and general ledger balance or between Chicago Appliance‘s and customer‘s records. (4) No mention was made of whether the fixed asset program was adequately tested. Although it is supposedly ―state of the art,‖ it may not compute depreciation and net book value on a basis consistent with Chicago Appliance‘s policies. (5) The fixed asset clerk‘s reluctance to use the computer implies that proper training may not have taken place. In addition, adequate systems or application documentation may not exist. Accordingly, improper use of the fixed asset program is not an unreasonable possibility. (6) The fixed asset processing appears to lack separation of duties. The fixed asset clerk will be responsible for processing future fixed asset transactions and generating general ledger entries. (7) It is relatively simple to use a personal computer to access data files. No mention was made as to whether any controls were established to prevent this from occurring; thus, it may be possible for the data files or programs to be improperly altered by using a personal computer as a terminal.

H.57

Internal Control Considerations in an End-User Computing Environments (Continued) b.

Implications for the audit plan

Audit teams should make inquiries to confirm whether some of the potential internal control weaknesses mentioned in (a) could affect the audit or are mitigated by other controls and procedures. However, based on the available information, the apparent weaknesses are significant enough to cause serious concern as to whether controls surrounding the end-user applications are sufficiently reliable to produce proper financial statement information. If audit teams determine that the internal control weaknesses are not mitigated by other controls and procedures, the audit approach in the fixed asset and accounts receivable areas would probably be based largely on substantive procedures. For example, audit teams might perform the confirmation of accounts receivable at year-end rather than an interim date to make certain that the detailed trial balance can be used to support the general ledger balance and to assess the reserve for bad debts. Audit teams must be aware that many of the control features that apply in larger ―mainframe‖ installations typically will not be present in the end-user environment. When personal computers are used in applications or situations similar to those in the Chicago Appliance case, control over accounting applications may be jeopardized by insufficient separation of duties, fewer processing controls, and a casual operating environment. When these circumstances are encountered, audit teams should inquire regarding other controls, such as (1) management involvement in the review and approval of transactions and reports and (2) clear and distinct audit trails over transaction processing to determine whether reliance on controls in end-user computing environments is warranted.

H.58

Test Data Transactions in a Payroll Processing Program TO: FROM: DATE: SUBJECT:

Audit Partner The Audit Team Control deficiencies in payroll calculation program

I tested the program for controls the client asserted were present and for controls that should exist in the program. Each is described in the following seven points. (Detail audit documentation showing the test transactions can be attached.) 1.

Program check for valid employee identification: The program does not actually check for valid employee identification as the client asserted. I studied the program code itself and saw that it checked for some valid social security numbers by disallowing numbers lower than the lowest number issued (001-01-0001) and numbers higher than the highest number currently issued (626-01-9999). It also disallowed numbers in the 700+ series for people with railroad retirement sequence numbers. I entered some fictitious numbers known not to be issued, and the system calculated gross and net pay.

Program test of pay rate for reasonableness: The program does not test for pay rates less than the minimum wage. I tested transactions with pay rates below minimum wage and they were processed. The program does test for unrealistically high pay rates (variable setting at $25 per hour or more), and this control works properly. There are no controls to verify that employees are paid at their approved rate. Employees can be expected to complain about being paid less than the rate authorized and get additional error-correction pay. Employees may or may not report being paid too much. Overpayments, if any, are expensed in the normal course of accounting, so net income will not be misstated. However, we can consider making a control recommendation to management about the possibility of overpayments that have a negative effect on net income.

Limit test on regular hours of 40 or more: The limit and reasonableness controls for disallowing regular pay for any hours in excess of 40 hours works properly. Test transactions with more than 40 regular hours returned the ―zero pay‖ error message. However, the program has no valid sign test. Test transactions with a negative number of regular hours calculated a negative amount of gross and net pay. We should scan the payroll register computer files to determine whether any ―negative pay‖ was calculated during the year.

Overtime hour control when regular time is less than 40 hours: Having found the limit and reasonableness test for regular hours of 40 or more, I noticed that the program will calculate and pay overtime hours even when the regular time is less than 40 hours. This is illogical. Employees cannot both work fewer than 40 regular hours and overtime hours (more than 40). Testing transactions with fewer than 40 regular hours and some overtime hours resulted in the preparation of a paycheck for the regular hours at the regular rate and the overtime hours at the overtime rate. We should consider a recommendation to management to institute the control of ―no overtime unless regular time exceeds 40 hours‖. This may save the client from paying the overtime rate for regular working hours.

Overtime paid at the rate of 150 percent of regular pay rate: The program is properly set up to calculate overtime pay at 150 percent of the regular pay rate based on the number of overtime hours input. Test transactions proved the program calculations. I also found the specification of 150 percent of the regular rate in the program code.

The client has an additional limit and reasonableness control on overtime pay. The program returns ―zero pay‖ for overtime more than a specified maximum number of hours. However, at the time of test, the maximum was 72 hours, indicating a potential allowable 16-hour workday, 7 days per week. Regular pay and deductions are calculated accurately. This could be a good limit test to prevent overreporting and input error on overtime pay if the limit were lower. H.58

Test Data Transactions in a Payroll Processing Program (Continued)

Notes to instructor: The following points might help you clarify this assignment to your students. They are not included in the body of the solution because it is intended to be a memo of the students’ test data results. They are cross-referenced to the numbered items in the memo. 1.

Students will need to know enough about EXCEL to recognize range names (SSNLO = lowest social security number and SSNHI = highest social security number) and then ask for /Range Name Create to find the location of the range. That will lead them to the undisclosed parameter specification section of the worksheet. There they will see the low and high social security numbers.

Students will need to find the parameter specification section to see the maximum regular pay rate range name RRATE, set at $25 in the program. The program has nothing to test for a wage rate less than $7.25 (minimum wage assumed) or an approved pay rate.

Students will need to find the parameter specification section to see the 40 hour limit test for regular hours worked in the range named REG. There is no sign test to prevent processing of negative time worked.

Students might identify the issue that overtime pay can be calculated when regular time is less than 40 hours by inference from reading the calculation formula. Otherwise, they will need to have the imagination to enter regular hours fewer than 40 and overtime hours to see that the program will produce a paycheck

Students can find the 150 percent in the range named OTR in the parameter specification section. They will also find the specification for the limit test on overtime hours in the range named OTM. If students do not find the parameter specification range, their ability to find the limit test on overtime hours depends on whether they entered more overtime hours than 72.

Auditing & Assurance Services 8th Edition by Louwers, Bagley, Blay, Strawser | SOLUTIONS MANUAL