Audit Reports
1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording.
: Auditor's reports are important to users of financial statements because
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Audit Reports
1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording.
: Auditor's reports are important to users of financial statements because they inform users of the auditor's opinion as to whether or not the statements are fairly stated or whether no conclusion can be made with regard to the fairness of their presentation. Users especially look for any deviation from the wording of the standard unqualified report and the reasons and implications of such deviations. Having standard wording improves communications for the benefit of users of the auditor’s report. When there are departures from the standard wording, users are more likely to recognize and consider situations requiring a modification or qualification to the auditor’s report or opinion.
2) List the seven parts of a standard unqualified audit report and explain the meaning of each part. How do the parts compare with those found in qualified report?
: The unqualified audit report consists of:
1. Report title Auditing standards require that the report be titled and that the title includes the word independent.
2. Audit report address The report is usually addressed to the company, its stockholders, or the board of directors.
3. Introductory paragraph The first paragraph of the report does three things: first, it makes the simple statement that the CPA firm has done an audit. Second, it lists the financial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash flows. Third, it states that the statements are the responsibility of management and that the auditor's responsibility is to express an opinion on the statements based on an audit.
4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the audit. The remainder briefly describes important aspects of an audit.
5. Opinion paragraph. The final paragraph in the standard report states the auditor's conclusions based on the results of the audit.
6. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the audit.
7. Audit report date. The appropriate date for the report is the one on which the auditor has completed the most important auditing procedures in the field.
The same seven parts are found in a qualified report as in an unqualified report. There are also often one or more additional paragraphs explaining reasons for the qualifications.
3) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important information included in the scope paragraph.
: The purposes of the scope paragraph in the auditor's report are to inform the financial statement users that the audit was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean, and whether the audit provides a reasonable basis for an opinion.
The information in the scope paragraph includes:
1. The auditor followed generally accepted auditing standards.
2. The audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement.
3. Discussion of the audit evidence accumulated.
4. Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express the opinion presented.
4) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important information included in the opinion paragraph.
: The purpose of the opinion paragraph is to state the auditor's conclusions based upon the results of the audit evidence. The most important information in the opinion paragraph includes:
1. The words "in our opinion" which indicate that the conclusions are based on professional judgment.
2. A restatement of the financial statements that have been audited and the dates thereof or a reference to the introductory paragraph.
3. A statement about whether the financial statements were presented fairly and in accordance with generally accepted accounting principles.
5) On February 17, 2006, a CPA completed the field work on the financial statements for the Buckheizer Technology Corporation for the year ended December 31, 2005. The audit in satisfactory in all respects except for the existence of a change in accounting principle from FIFO to LIFO inventory valuation., which results in an explanatory paragraph to consistency. On February 26, the auditor completed the tax return and the draft of the financial statements. The final audit report was completed, attached to the financial statements, and delivered to the client on March 7. What is the appropriate date on the auditor’s report?
: The auditor's report should be dated February 17, 2006, the date on which the auditor completed the most important auditing procedures in the field.
6) What five circumstances are required for a standard unqualified report to be issued?
: An unqualified report may be issued under the following five circumstances:
1. All statements—balance sheet, income statement, statement of retained earnings, and statement of cash flows—are included in the financial statements.
2. The three general standards have been followed in all respects on the engagement.
3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables him or her to conclude that the three standards of field work have been met.
4. The financial statements are presented in accordance with generally accepted accounting principles. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements.
5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report.
7) Describe the additional information included in the introductory, scope, and opinion paragraphs in a combined audit report on financial statements and the effectiveness of internal control over
financial reporting. What is the nature of the additional paragraphs in the audit report?
: The introductory, scope and opinion paragraphs are modified to include reference to management’s report on internal control over financial reporting, and the scope of the auditor’s work and opinion on internal control over financial reporting. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two additional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the inherent limitations of internal control.
8) What type of opinion should an auditor issue when the financial statements are not in accordance with GAAP because such adherence would result in misleading statements?
: When adherence to generally accepted accounting principles would result in misleading financial statements there should be a complete explanation in a separate paragraph. The separate paragraph should fully explain the departure and the reason why generally accepted accounting principles would have resulted in misleading statements. The opinion should be unqualified, but it should refer to the separate paragraph during the portion of the opinion in which generally accepted accounting principles are mentioned.
9) Distinguish between an unqualified report with explanatory paragraph or modified wording and a qualified report. Give examples when an explanatory paragraph or modified wording should be used in an unqualified opinion.
: An unqualified report with an explanatory paragraph or modified wording is the same as a standard unqualified report except that the auditor believes it is necessary to provide additional information about the audit or the financial statements. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are fairly presented.
Two examples of an unqualified report with an explanatory paragraph or modified wording are:
1. The entity changed from one generally accepted accounting principle to another generally accepted accounting principle.
2. A shared report involving the use of other auditors.
10) Describe what is meant by a reports involving the use of other auditors. What are the three options available to the principal auditor and when should each be used?
: When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports based on the circumstances.
1. No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the other auditor's work.
2. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is impractical to review the work of the other auditor or when a portion of the financial statements audited by the other CPA is material in relation to the total.
3. The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material.
11) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should be this reflected in the auditor’s report?
: Even though the prior year statements have been restated to enhance comparability, a separate explanatory paragraph is required to explain the change in generally accepted accounting principles in the first year in which the change took place.
12) Distinguish between changes that affect consistency and those that may affect comparability but not consistency. Give an example of each.
: Changes that affect the consistency of the financial statements may involve any of the following:
a. Change in accounting principle
b. Change in reporting entity
c. Corrections of errors involving accounting principles.
An example of a change that affects consistency would be a change in the method of computing depreciation from straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material.
Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the statements. In that case, no explanatory paragraph for lack of consistency is needed, but the information may require disclosure in the statements.
13) List the three conditions that require a departure from unqualified opinion and give one specific example of each those conditions.
: The three conditions requiring a departure from an unqualified opinion are:
1. The scope of the audit has been restricted. One example is when the client will not permit the auditor to confirm material receivables. Another example is when the engagement is not agreed upon until after the client's year-end when it may be impossible to physically observe inventories.
2. The financial statements have not been prepared in accordance with generally accepted accounting principles. An example is when the client insists upon using replacement costs for fixed assets.
3. The auditor is not independent. An example is when the auditor owns stock in the client's business.
14) Distinguish between a qualified opinion, adverse opinion, and a disclaimer of opinion, and explain the circumstances under which each is appropriate.
: A qualified opinion states that there has been either a limitation on the scope of the audit or a departure from GAAP in the financial statements, but that the auditor believes that the overall financial statements are fairly presented. This type of opinion may not be used if the auditor believes the exceptions being reported upon
are extremely material, in which case a disclaimer or adverse opinion would be used.
An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or misleading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash flows.
A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as to whether or not the overall financial statements are fairly presented because of a significant limitation of the scope of the audit, or a non-independent relationship under the Code of Professional Conduct between the auditor and the client.
Examples of situations that are appropriate for each type of opinion are as follows:
OPINION TYPE EXAMPLE SITUATION
Disclaimer Material physical inventories not observed and the inventory cannot be verified through other procedures.
Lack of independence by the auditor.
Adverse A highly material departure from GAAP.
Qualified Inability to confirm the existence of an asset which is material but not extremely material in value.
15) Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of materiality?
: The common definition of materiality as it applies to accounting and, therefore, to audit reporting is:
A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements.
Conditions that affect the auditor's determination of materiality include:
Potential users of the financial statements
Dollar amounts of the following items: net income before taxes, total assets, current assets, current liabilities, and owners' equity
Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more important to users of the financial statements than other misstatements.
16) Explain how materiality differs for failure to follow GAAP and for lack of independence.
: Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined by the Code of Professional Conduct, it is always considered highly material and therefore a disclaimer of opinion is always necessary. That is, either the CPA is independent or not independent. For failure to follow GAAP, there are three levels of materiality: immaterial, material, and highly material.
17) How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations resulting from conditions beyond the client’s control? Under which of these two
would the auditor be most likely to issue a disclaimer of opinion? Explain.
: The auditor's opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting from conditions beyond the client's control. The former occurs when the client will not, for example, permit the auditor to confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed upon until after the client's year-end when it may not be possible to physically observe inventories or confirm receivables.
A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall financial statements are fairly presented. If the scope limitation is caused by the client's restriction the auditor should be aware that the reason for the restriction might be to deceive the auditor. For this reason, a disclaimer is more likely for client restrictions than for conditions beyond anyone's control.
When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opinion may be issued. This is more likely when the scope limitation is for conditions beyond the client's control than for restrictions by the client.
18) Distinguish between a report qualified as to opinion only and one with both a scope and opinion qualification.
: A report with a scope and an opinion qualification is issued when the auditor can neither perform procedures that he or she considers necessary nor satisfy him or herself by using alternative procedures, due to the existence of conditions beyond the client's or the auditor's control, but the amount involved in the financial statements is not highly material. An important part of a scope and opinion qualification is that it results from not accumulating sufficient audit evidence, either because of the client's request or because of circumstances beyond anyone's control.
A report qualified as to opinion only results when the auditor has accumulated sufficient competent evidence but has concluded that the financial statements are not correctly stated. The only circumstance in which an opinion only qualification is appropriate is for material, but not highly material, departures from GAAP.
19) Identify the three alternative opinion that may be appropriate when the client’s financial statements are not accordance with GAAP. Under what circumstances is each appropriate.
: The three alternative opinions that may be appropriate when the client's financial statements are not in accordance with GAAP are an unqualified opinion, qualified as to opinion only and adverse opinion. Determining which is appropriate depends entirely upon materiality. An unqualified opinion is appropriate if the GAAP departure is immaterial (standard unqualified) or if the auditor agrees with the client's departure from GAAP (unqualified with explanatory paragraph). A qualified opinion is appropriate when the deviation from GAAP is material but not highly material; the adverse opinion is appropriate when the deviation is highly material.
20) Discuss why the AICPA has such strict requirements on audit opinions when the auditor is not independent.
: The AICPA has such strict requirements on audit opinions when the auditor is not independent because it is important that stockholders and other third parties be absolutely assured that the auditor is unbiased throughout the entire engagement. If users develop the attitude that auditors are not independent of management, the value of the audit function will be greatly reduced, if not eliminated.
21) When an auditor discovers more than one condition that requires departure from or modification of standard unqualified report, what should the auditor’s report include?
: When the auditor discovers more than one condition that requires a departure from or a modification of a standard unqualified report, the report should be modified for each condition. An exception is when one condition neutralizes the other condition. An example would be when the auditor is not independent and there is also a scope limitation. In this situation the lack of independence overshadows the scope limitation. Accordingly, the scope limitation should not be mentioned.
22) What responsibility does the auditor have for information on the company’s web site that may be inked to electronic versions of the company’s annual financial statements and auditor’s report? How does this differ from the auditor’s responsibility for other information in the company’s annual report that includes the financial statements and auditor’s report?
: Under current auditing standards, auditors are not required to read information contained in electronic sites, such as the company’s Web site, that also contain the company’s audited financial statements and the auditor’s report. Auditing standards do not consider electronic sites to be “documents.” This is different from the auditor’s responsibility for published (hard copy) documents that contain information in addition to audited financial statements and the auditor’s report. In this latter example, the auditor is responsible for reading other information that is published with audited financial statements and the auditor’s report to determine whether it is materially inconsistent with information in the audited financial statements.
The Audit Process-Audit Responsibilities and objectives
1) State the objective of the audit of financial statements. In general terms, how do auditors meet that objective?
: The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.
The auditor meets that objective by accumulating sufficient competent evidence to determine whether the financial statements are fairly stated.
2) Distinguish between management’s and auditor’s responsibility for the financial statements being audited.
: It is management's responsibility to adopt sound accounting policies, maintain adequate internal control and make fair representations in the financial statements. The auditor's responsibility is to conduct an audit of the financial statements in accordance with auditing
standards and report the findings of the audit in the auditor's report.
3) Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each?
: An error is an unintentional misstatement of the financial statements. Fraud represents intentional misstatements. The auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are detected, whether those misstatements are due to errors or fraud.
An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial statements. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement. Because there is an attempt at concealment of fraud, material misstatements due to fraud are usually more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud) are not uncovered in the audit is that the audit was conducted in accordance with auditing standards.
4) Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the likely difference between those two types of fraud on the fair presentation of financial statements.
: Misappropriation of assets represents the theft of assets by employees. Fraudulent financial reporting is the intentional misstatement of financial information by management or a theft of assets by management, which is covered up by misstating financial statements.
Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing controls. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial statements. There are also the cases of large theft of assets that result in bankruptcy to the company. Fraudulent financial reporting is inherently difficult to uncover because it is possible for one or more members of management to override internal controls. In many cases the amounts are extremely large and may affect the fair presentation of financial statements
5) “It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain large amounts of information from management and to rely heavily on management’s judgments. After all, the financial statements are management’s representations, and simple, it is extremely difficult, if not impossible, for the auditor to evaluate the obsolescence inventory as well as management can in a highly complex business. Similarly, the collectability of accounts receivable and the continued usefulness of machinery and equipment are heavily dependent on management’s willingness to provide truthful responses to questions.” Reconcile the auditor’s responsibility for discovering material misrepresentations by management with these comments.
: True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the auditor must not accept management's representations blindly. The auditor must, whenever possible, obtain competent evidential matter to support the representations of management. As an example, if management represents that certain inventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the inventory is being sold at a price that is higher than the company's cost plus selling expenses. If management represents an account receivable as
being fully collectible, the auditor should be able to examine subsequent payments by the customer or correspondence from the customer that indicates a willingness and ability to pay.
6) List two major characteristics that are useful in predicting the likelihood of fraudulent financial reporting in an audit. For each of the characteristics, state two things that the auditor can do to evaluate its significance in the engagement.
:
CHARACTERISTIC AUDIT STEPS
1. Management’s characteristics and influence over the control environment. Investigate the past history of the firm and its management.
Discuss the possibility of fraudulent financial reporting with previous auditor and company legal counsel after obtaining permission to do so from management.
2. Industry conditions. Research current status of industry and compare industry financial ratios to the company’s ratios.
Investigate any unusual differences.
Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available. Consider the impact of specific risks that are identified on the conduct of the audit.
3. Operating characteristics and financial stability. Perform analytical procedures to evaluate the possibility of business failure.
Investigate whether material transactions occur close to year- end.
7) Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit into different cycles?
: The cycle approach is a method of dividing the audit such that closely related types of transactions and account balances are included in the same cycle. For example, sales, sales returns, and cash receipts transactions and the accounts receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycles are to divide the audit into more manageable parts, to assign tasks to different members of the audit team, and to keep closely related parts of the audit together.
8) Identify the cycle to which each of the following ledger accounts would ordinarily be assigned: sales, account payable, retained earnings, account receivable, inventory and repairs and maintenance.
:
Sales Sales & Collection
Accounts Payable Acquisition & Payment
Retained Earnings Capital Acquisition & Repayment
Accounts Receivable Sales & Collection
Inventory Inventory & Warehousing
Repairs & Maintenance Acquisition & Payment
9) Why are sales, sales R&A, bad debts, cash discounts, AR, and allowance for uncollectible accounts all included in the same cycle?
: There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not be separated. Bad debt expense is closely related to the allowance for uncollectible accounts. To separate these accounts from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their relationships in mind.
10) Define what is meant by a management assertion about financial statements. Identify the five board categories of management assertions.
: Management assertions are implied or expressed representations by management about classes of transactions and the related accounts in the financial statements. These assertions are part of the criteria management uses to record and disclose accounting information in financial statements. SAS 31 (AU 326) classifies five broad categories of assertions:
1. Existence or occurrence
2. Completeness
3. Valuation or allocation
4. Rights and obligations
5. Presentation and disclosure
11) Distinguish between the general audit objectives and management assertions. Why are the general audit objectives more useful to auditors?
: General audit objectives follow from and are closely related to management assertions. General audit objectives, however, are intended to provide a framework to help the auditor accumulate sufficient competent evidence required by the third standard of field work. Audit objectives are more useful to auditors than assertions because they are more detailed and more closely related to helping the auditor accumulate sufficient competent evidence.
12) An acquisition of fixed-asset repair by a construction company is recorded on the wrong date. Which transaction-related audit objective has been violated? Which transaction-related audit objective has been violated if the acquisition had been capitalized as a fixed asset rather than expensed?
:
RECORDING MISSTATEMENT TRANSACTION-RELATED AUDIT
OBJECTIVE VIOLATED
Fixed asset repair is recorded on the wrong date.
Repair is capitalized as a fixed asset instead of an expense. Timing
Classification
13) Distinguish between the existence and completeness balance- related audit objectives. State the effect on financial statements (overstatement or understatement) of a violation of each in the audit of accounts receivable.
: The existence objective deals with whether amounts included in the financial statements should actually be included. Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be included have actually been included.
In the audit of accounts receivable, a nonexistent account receivable will lead to overstatement of the accounts receivable balance. Failure to include a customer's account receivable balance, which is a violation of completeness, will lead to understatement of the accounts receivable balance.
14) What are specific audit objectives? Explain their relationship to the general audit objectives.
: Specific audit objectives are the application of the general audit objectives to a given class of transactions or account balance. There must be at least one specific audit objective for each general audit objective and in many cases there should be more. Specific audit objectives for a class of transactions or an account balance should be designed such that, once they have been satisfied, the related general audit objective should also have been satisfied for that class of transactions or account.
15) Identify the management assertion and general balance-related audit for the specific balance-related audit objective: All recorded fixed assets exist at the balance sheet date.
: For the specific balance-related audit objective, all recorded fixed assets exist at the balance sheet date, the management assertion and the general balance-related audit objective are both "existence."
16) Explain how management assertions, general balance-related audit objectives, and specific balance-related audit objectives are developed for an account balance such as accounts receivable.
: Management assertions and general balance-related audit objectives are consistent for all asset accounts for every audit. They were developed by the Auditing Standards Board, practitioners, and academics over a period of time. One or more specific balance-related audit objectives are developed for each general balance-related audit objective in an audit area such as accounts receivable. For any given account, a CPA firm may decide on a consistent set of specific balance-related audit objectives for accounts receivable, or it may decide to use different objectives for different audits.
17) Identify the four phases of the audit. What is the relationship of the four phases to the objective of the audit of financial statements?
: The four phases of the audit are:
1. Plan and design an audit approach.
2. Perform tests of controls and substantive tests of transactions.
3. Perform analytical procedures and tests of details of balances.
4. Complete the audit and issue an audit report.
The auditor uses these four phases to meet the overall objective of the audit, which is to express an opinion on the fairness with which the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows in conformity with GAAP. By accumulating sufficient competent evidence for each audit objective, the overall objective is met. The accumulation of evidence is accomplished by performing the four phases of the audit.
The Audit Process-Audit Evidence
1) Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements.
: In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclusions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example, if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defendant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient competent evidence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is correct, but rather must obtain a high level of assurance.
The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reliable types of evidence such as confirmation with third parties, physical examination, and documentation are also used extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after evaluating the evidence.
2) List the four major evidence decisions that must be made on every audit.
: The four major audit evidence decisions that must be made on every audit are:
1. Which audit procedures to use.
2. What sample size to select for a given procedure.
3. Which items to select from the population.
4. When to perform the procedure.
3) Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully worded?
: An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Because audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to make sure the instructions are clear.
4) Describe what is meant by an audit program for accounts receivable. What four things should be included in an audit program?
: An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.
5) State the third standard of field work. Explain the meaning of each of the major phrases of the standard.
: Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. There are three major phrases of the standard.
PHRASE MEANING OF PHRASE
Sufficient competent evidence
Through inspection, observation, inquiries and confirmations
To afford a reasonable basis for an opinion regarding the financial statements The auditor must obtain evidence that is reliable and there must be a reasonable quantity of that evidence.
These are the major types of evidence available for the auditor to use.
The auditor cannot expect to be completely certain that the financial statements are fairly presented but there must be persuasive evidence. The collection of evidence gathered by the auditor provides the basis for the auditor's opinion.
6) Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced, that the financial statements are correct.
: There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather than be convinced that the financial statements are correct:
1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced.
2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client.
7) Identify the two factors, that determine the persuasiveness of evidence. How are these two factors related to audit procedures, sample size, items to select, and timing?
: The two determinants of the persuasiveness of evidence are competency and sufficiency. Competency refers to the degree to which evidence can be considered believable or worthy of trust. Competency relates to the audit procedures selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and it is related to sample size and items to select.
8) Identify the seven characteristics that determine the competence of evidence. For each characteristics, provide one example of a type of evidence that is likely to be competent.
7.8 : Following are seven characteristics that determine competence and an example of each.
FACTOR
DETERMINING COMPETENCE EXAMPLE OF
COMPETENT EVIDENCE
Relevance Trace inventory items located in the
warehouse to their inclusion in the
inventory subsidiary records
Independence of provider Confirmation of a bank balance
Effectiveness of client's internal controls
Use of duplicate sales invoices for a
large well-run company
Auditor's direct knowledge Physical examination of inventory by the auditor
Qualifications of provider Letter from an attorney dealing with the
client's affairs
Degree of objectivity
Count of cash on hand by auditor
Timeliness Observe inventory on the last day of the
fiscal year
9) List the seven types of audit evidence included in this chapter and give two examples of each.
:
TYPES OF AUDIT EVIDENCE EXAMPLES
1. Physical examination
2. Confirmation Count petty cash on hand
Examine fixed asset additions
Confirm accounts receivable balances of a sample of client customers
Confirm client’s cash balance with bank
3. Documentation
4. Analytical procedures Examine cancelled checks returned with cutoff bank statement
Examine vendors’ invoices supporting a sample of cash disbursement transactions throughout the year
Evaluate reasonableness of receivables by calculating and comparing ratios
Compare expenses as a percentage of net sales with prior year’s percentages
TYPES OF AUDIT EVIDENCE EXAMPLES
5. Inquiries of the client
6. Re-performance
7. Observation Inquire of management whether there is obsolete inventory
Inquire of management regarding the collectibility of large accounts receivable balances
Re-compute invoice total by multiplying item price times quantity sold
Food the sales journal for a one-month period and compare all totals to the general ledger
Observe client employees in the process of counting inventory
Observe whether employees are restricted from access to the check signing machine
10) What are the four characteristics of the definition of a confirmation?
Distinguish between a confirmation and external documentation.
: The four characteristics of the definition of a confirmation are:
1. Receipt
2. Written or oral response
3. From independent third party
4. Requested by the auditor
A confirmation is prepared specifically for the auditor and comes from an external source. External documentation is in the hands of the client at the time of the audit and was prepared for the client's use in the day-to-day operation of the business.
11) Distinguish between internal documentation and external documentation as audit evidence and give three examples of each.
: Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor.
Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor.
Examples:
check request form
receiving report
payroll time card
adjusting journal entry
External documentation either originated with an outside party or was an internal document that went to an outside party and is now either in the hands of the client or is readily accessible.
Examples:
vendor's invoice
cancelled check
cancelled note
validated deposit slip
12) Explain the importance of analytical procedures as evidence in
determining the fair presentation of the financial statements.
: Analytical procedures are useful for indicating account balances that may be distorted by unusual or significant transactions and that should be intensively investigated. They are also useful in reviewing accounts or transactions for reasonableness to corroborate tentative conclusions reached on the basis of other evidence.
13) Identify the most important reasons for performing analytical procedures.
: The most important reasons for performing analytical procedures are the following:
1. Understanding the client's industry and business
2. Assessment of the entity's ability to continue as a going concern
3. Indication of the presence of possible misstatements in the financial statements
4. Reduction of detailed audit tests
14) Your client, Harper Company, has a contractual commitment as a part of a bond indenture to maintain a current ratio of 2.0. if the ratio falls below that level on the balance sheet date, the entire bond becomes payable immediately. In the current year, the client’s financial statements show that the ratio has dropped from 2.6 to
2.05 over the past year. How should this situation affect your audit plan?
: The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that the 2.05 ratio is proper since management would be motivated to hide any lower ratio. The auditor should expand procedures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper cutoff and possible understatement.
15) Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce detailed substantive procedures.
: Attention directing analytical procedures occur when significant, unexpected differences are found between current year's unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must determine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or misstatement due to fraud.
When an analytical procedure reveals no unusual fluctuations, the implication is minimized. In that case, the analytical procedure constitutes substantive evidence in support of the fair statement of the related account balances, and it is possible to perform fewer detailed substantive tests in connection with those accounts.
Frequently, the same analytical procedures can be used for attention directing and for reducing substantive tests, depending on the outcome of the tests. Simple procedures such as comparing the current year account balance to the prior year account balance is more attention directing (and provides less assurance) than more complex analytical procedures; i.e., those which rely on regression analysis. More sophisticated analytical procedures help the auditor examine relationships between several information variables simultaneously. The nature of these tests may provide greater assurance than simple procedures.
16) Explain why the statement “Analytical procedures are essential in every part of an audit, but these tests are rarely sufficient by themselves for any audit area” is correct or incorrect.
: The statement is correct. Except for certain accounts with small dollar balances, analytical procedures are essential to help the auditor identify trends in a client's business and to see the relationship between the client's performance and industry averages. However, the auditor is responsible for gathering sufficient competent evidential matter through inspection, observation and confirmation in addition to the evidence obtained as a result of the analytical procedures.
17) List the purposes of audit documentation and explain why each purpose is important.
: The purposes of audit documentation are as follows:
1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc.
2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed.
3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated.
4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient competent evidence was accumulated to justify the audit report.
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient competent evidence if there's a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
The purposes of audit documentation are as follows:
1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc.
2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed.
3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated.
4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient competent evidence was accumulated to justify the audit report.
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient competent evidence if there's a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
18) What are the two criteria that auditors of public companies consider when determining whether memos, correspondence, and other documents must be maintained in the audit files?
: The two criteria used by auditors of public companies when determining whether memos, correspondence, and other documents must be maintained in the audit files are as follows:
1. The materials are created, sent, or received in connection with the audit or review.
2. The materials contain conclusions, opinions, analyses, or financial data related to the audit or review.
19) For how long does the Sarbanes-Oxley Act require auditors of public companies to retain audit documentation?
: The Sarbanes-Oxley Act of 2002 requires auditors of public companies to prepare and maintain audit schedules and other information related to any audit report in sufficient detail to support the auditor’s conclusions, for a period of not less than 7 years.
20) Explain why it is important for audit documentation to include each of the following: identification of the name of the client, period covered, description of the contents, initial of the preparer, date of the preparation, and an index code.
: Audit schedules should include the following:
Name of the client Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from the files.
Period covered Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is removed from the files.
Description of the contents A list of the contents enables the reviewer to determine whether all important parts of the audit schedule have been included. The contents description is also used as a means of identifying audit files in the same manner that a table of contents is used.
Initials of the preparer Indicates who prepared the audit schedule in case there are questions by the reviewer or someone who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit documentation if the audit must be defended.
Date of preparation Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also useful for the subsequent year in planning the sequence of preparing audit schedules.
Indexing Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of the audit documentation.
21) Define what is meant by a permanent file, and list several types of information typically included. Why does the auditor not include the contents of the permanent file with the current year’s audit file?
: The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of items included in the file are:
1. Articles of incorporation
2. Bylaws, bond indentures, and contracts
3. Analysis of accounts that have continuing importance to the auditor
4. Information related to the understanding of internal control:
a. flowcharts
b. internal control questionnaires
5. Results of previous years' analytical procedures, such as various ratios and percentages compiled by the auditors
By separating this information from the current year's audit files, it becomes easily accessible for the following year's auditors to obtain permanent file data.
22) Distinguish between the following types of current period supporting schedules and state the purpose of each: analysis, trial balance, and tests of reasonableness.
: The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, tying together the beginning and ending balances. The trial balance includes the detailed make-up of an ending balance. It differs from an analysis in that it includes only those items comprising the end of the period balance. A test of reasonableness schedule contains information that enables the auditor to evaluate whether a certain account balance appears to be misstated. One example of a test of reasonableness schedule is a schedule that compares current year expenses to prior years' amounts. This type of schedule is intended to show which accounts need investigation due to significant variances.
23) Why is it essential that the auditor not leave questions or exceptions in the audit documentation without an adequate explanation?
: Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial statements. These should be investigated and resolved to make sure that financial statements are fairly presented.
The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate lack of due care by the auditor.
24) Define what is meant by a tick mark. What is its purpose?
: Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what was done and who did it.
25) Who owns the audit files? Under what circumstances can they be used by other people?
: Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a careful consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court and thereby become the property of the court. They can be released to another CPA firm without the client's permission if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from the client.
26)A CPA sells his auditing practice to another CPA firm and includes all audit files as part of the purchase price. Under what circumstances is this a violation of the code of professional conduct?
: It is a violation unless the CPA obtains permission from each client before the audit files for that client are released.
27) How does the auditor read and evaluate information that is available only in machine-readable form?
: When evidence can be examined only in machine-readable form, auditors use computers to read and examine evidence. There are commercial audit software programs designed specifically for use by auditors, such as ACL Software and Interactive Data Extraction and Analysis (IDEA). Spreadsheet software packages can also be used by auditors to perform audit tests on data that is available only in machine-readable form.
28) Explain the purposes and benefits of audit documentation software.
: The purposes of audit documentation software are to convert traditional paper-based documentation into electronic files and to organize the audit documentation. The benefits of audit documentation software, such as Automated Client Engagement (ACE), are as follows:
The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial statements, and ratio analysis using the computer rather than by hand.
The effects of adjusting journal entries are automatically carried through to the trial balance and financial statements, making last-minute adjustments easier to make.
Tick marks and review notes can be entered directly into computerized files.
Data can be imported and exported to other applications. For example, a client’s general ledger can be downloaded into ACE and tax information can be downloaded into a commercial tax preparation package after the audit is completed.
The Audit Process-Audit Planning and Analytical Procedures
1) what benefits does the auditor derive from planning audits?
: There are three primary benefits from planning audits: it helps the auditor obtain sufficient competent evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client.
2) Identify the eight major steps in planning audits.
: Eight major steps in planning audits are:
1. Accept client and perform initial planning
2. Understand the client’s business and industry
3. Assess client business risk
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent risk
6. Understand internal control and assess control risk
7. Gather information to assess fraud risks
8. Develop overall audit plan and audit program
3) What are the responsibilities of the successor and predecessor auditors when a company is changing auditors?
: The new auditor (successor) is required by SAS 84 (AU 315) to communicate with the predecessor auditor. This enables the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement. Permission must be obtained from the client before communication can be made because of the confidentiality requirement in the Code of Professional Conduct. The predecessor is required to respond to the successor’s request for information; however, the response may be limited to stating that no information will be given. The successor auditor should be wary if the predecessor is reluctant to provide information about the client.
4) What factors should an auditor consider prior to accepting an engagement? Explain.
: Prior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client’s standing in the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially concerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud.
5) What is the purpose of an engagement letter? What subjects should be covered in such a letter?
: An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and related services. It should state what services will be provided, whether any restrictions will be imposed on the auditor’s work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter may also include the auditor’s fees. In addition, the engagement letter informs the client that the auditor cannot guarantee that all acts of fraud will be discovered.
6) Who is considered “the client” when auditing public companies?
: Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements.
7) Which services must be preapproved by the audit committee a public company?
: All audit and non-audit services must be preapproved in advance by the audit committee for public companies.
8) Explain why auditors need an understanding of the client’s industry. What sources are commonly used by auditors to learn about the client’s industry?
: Auditors need an understanding of the client’s business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of these risks to determine the appropriate extent of audit evidence to accumulate.
The five major aspects of understanding the client’s business and industry, along with potential sources of information that auditors commonly use for each of the five areas are as follows:
1. Industry and External Environment – Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements.
2. Business Operations and Processes – Tour the plant and offices, identify related parties, and inquire of management.
3. Management and Governance – Read the corporate charter and bylaws, read minutes of board of directors and stockholders, and inquire of management.
4. Client Objectives and Strategies – Inquire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and other legal documents, such as those for notes and bonds payable, stock options, and pension plans.
5. Measurement and Performance – Read financial statements, perform ratio analysis, and inquire of management about key performance indicators that management uses to measure progress toward its objectives.
9) When a CPA has accepted an engagement from a new client who is manufacturer, it is customary for the CPA to tour the client’s plant facilities. Discuss the ways in which the CPA’s observations made during the course of the plant tour will be of help in planning and conducting the audit.
: During the course of the plant tour the CPA will remember that an important aspect of the audit will be an effective analysis of the cost system. Therefore, the auditor will observe the nature of the company’s products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system.
The nature of the company’s products and the manufacturing facilities and processes will reveal the features of the cost system that will require close audit attention. For example, the audit of a company engaged in the custom-manufacture of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the same basis. The CPA will note the stages at which finished products emerge and where additional materials must be added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advisable, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in similar audits.
The auditor’s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor determines that the company has recently installed new equipment or constructed a new building, he or she will expect to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this regard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in mind for further investigation any apparently obsolete inventory.
The auditor’s study of the flow of materials will disclose the points at which various documents such as material requisitions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be alert for the attitude of the manufacturing personnel toward accounting controls. The CPA may make some inquiries about the methods of production scheduling, timekeeping procedures and whether work standards are employed. As a result of these observations, the internal documents that relate to the flow of materials will be more meaningful as accounting evidence.
The CPA’s tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to communicate fluently with the client’s personnel. The measures
taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client’s attention to internal control measures. The location of the receiving and shipping departments and the procedures in effect will bear upon the CPA’s evaluation of internal control. The auditor’s overall impression of the client’s plant will suggest the accuracy and adequacy of the accounting records that will be audited.
10) An auditor often tries to acquire background knowledge of the client’s industry as an aid to audit work. How does the acquisition of this knowledge aid the auditor in distinguishing between obsolete and current inventory?
: One type of information the auditor obtains in gaining knowledge about the clients’ industry is the nature of the client’s products, including the likelihood of their technological obsolescence and future salability. This information is essential in helping the auditor evaluate whether the client’s inventory may be obsolete or have a market value lower than cost.
11) Define what is meant by a related party. What are the auditor’s responsibilities for related parties and related party transactions?
: A related party is defined in SAS 45 (AU 334) as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other.
Material related party transactions must be disclosed in the financial statements by management. Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements.
12) Which types of loans to executives are permitted by the Sarbanes- Oxley Act?
: Because of the lack of independence between the parties involved, the Sarbanes-Oxley Act prohibits related party transactions that involve personal loans to executives. It is now unlawful for any public company to provide personal credit or loans to any director or executive officer of the company. Banks or other financial institutions are permitted to make normal loans to their directors and officers using market rates, such as residential mortgages.
13) Your firm has performed the audit of Rogers Company for several years and you have been assigned the audit responsibility for the current audit. How would you review of the corporate charter and bylaws for this audit differ from that of the audit of a client who was audited by a different CPA firm in the preceding year?
: In the audit of a client previously audited by a different CPA firm, it would be necessary to obtain a copy of the corporate charter and bylaws for the permanent files and to read these documents and prepare a summary abstract of items to test for compliance. In an ongoing engagement, this work has been performed in the past and is unnecessary each year. The auditor’s responsibility is to determine what changes have been made during the current year and to update and review the summary abstract prepared in previous years for compliance.
14) For the audit of Radline Manufacturing Company, the audit partner asks you to carefully read the new mortgage contract with the First National Bank and abstract all pertinent information. List the information in a mortgage that is likely to be relevant to the auditor.
The information in a mortgage that is likely to be relevant to the auditor includes the following:
1. The parties to the agreement
2. The effective date of the agreement
3. The amounts included in the agreement
4. The repayment schedule required by the agreement
5. The definition and terms of default
6. Prepayment options and penalties specified in the agreement
7. Assets pledged or encumbered by the agreement
8. Liquidity restrictions imposed by the agreement
9. Purchase restrictions imposed by the agreement
10. Operating restrictions imposed by the agreement
11. Requirements for audit reports or other types of reports on compliance with the agreement
12. The interest rate specified in the agreement
13. Any other requirements, limitations, or agreements specified in the document
15) Identify two types of information in the client’s minutes of the board of directors meetings that are likely to be relevant to the auditor. Explain why it is important to read the minutes early in the engagement.
: Information in the client’s minutes that is likely to be relevant to the auditor includes the following:
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of conducting the audit. For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain that the loan is recorded as part of long- term liabilities.
16) Identify the three categories of client objectives. Indicate how each objective may affect the auditor’s assessment of inherent risk and evidence accumulation.
: The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with laws and regulations. Each of these objectives affects the auditor’s assessment of inherent risk and evidence accumulation as follows:
1. Reliability of financial reporting – If management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce inherent risk and planned evidence accumulation for material accounts. In contrast, if management has little regard for the reliability of financial reporting, the auditor must increase inherent risk assessments and gather more evidence during the audit.
2. Effectiveness and efficiency of operations – This area is of primary concern to
most clients. Auditors need knowledge about the effectiveness and efficiency of a client’s operations in order to assess client business risk and inherent risk in the financial statements. For example, if a client is experiencing inventory management problems, this would most likely increase both the auditor’s assessment of inherent risk for the planned evidence accumulation for inventory.
3. Compliance with laws and regulations – It is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client. For example, the provisions in a
pension plan document would significantly affect the auditor’s assessment of inherent risk and evidence accumulation in the audit of unfunded liability for pensions. If the client were in violation of the provisions of the pension plan document, inherent risk and planned evidence for pension-related accounts would increase.
17) What is the purpose of the client’s performance measurement system? Give examples of key performance indicators for the following business: (1) a chain of retail clothing stores; (2) an internet portal; (3) a hotel chain.
: The purpose of a client’s performance measurement system is to measure the client’s progress toward specific objectives. Performance measurement includes ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line. An Internet portal’s performance measurements might include number of Web site hits or search engine speed. A hotel chain’s performance measures include vacancy percentages and supply cost per rented room.
18) Define client business risk and describe several sources of client business risk. What is the auditor’s primary concern when evaluating client business risk?
: Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk include any of the factors affecting the client and its environment, including competitor performance, new technology, industry conditions, and the regulatory environment. The auditor’s primary concern when evaluating client business risk is the risk of material misstatements in the financial statements due to client business risk. For example, if the client’s industry is experiencing a significant and unexpected downturn, client business risk increases. This increase would most likely increase the risk of material misstatements in the financial statements. The auditor’s assessment of the risk of
material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of audit evidence.
19) Describe top management controls and their relation to client business risk. Give examples of effective management and governance controls.
: Management establishes the strategies and business processes followed by a client’s business. One top management control is management’s philosophy and operating style, including management’s attitude toward the importance of internal control. Other top management controls include a well-defined organizational structure, an effective board of directors, and an involved and effective audit committee. If the board of directors is effective, this increases management’s ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of overly aggressive accounting.
20) What are the purposes of preliminary analytical procedures? What types of comparisons are useful when performing preliminary analytical procedures?
: Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining the nature, extent, and timing of work to be performed. Preliminary analytical procedures also help the auditor identify accounts and classes of
transactions where misstatements are likely. Comparisons that are useful when performing preliminary analytical procedures include:
Compare client and industry data
Compare client data with similar prior period data
Compare client data with client-determined expected results
Compare client data with auditor-determined expected results
Compare client data with expected results, using nonfinancial data
21) When are analytical procedures required to be performed during the audit? What is the primary purpose of analytical procedures performed during the completion phase of the audit?
: Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit, but they are not required in this phase.
22) Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For several engagement, he computed the industry ratios included in publications by Robert Morris Associates and compared them with industry standards. For most engagements, the client’s business was significantly different from the industry data in the publication and the client would automatically explain away any discrepancies by attributing them to the unique nature of its operations. In cases in which the client had more than one branch in different industries, Gordon found the ratio analysis no help at all. How could Gordon improve the quality of his analytical procedures?
: Gordon could improve the quality of his analytical tests by:
1. Making internal comparisons to ratios of previous years.
2. In cases where the client has more than one branch in different industries, computing the ratios for each branch and comparing these to the industry ratios.
23) At the completion of every audit, Roger Morris, CPA, calculates a large number of ratios and trends for comparison with industry averages and prior-year calculations. He believes the calculations are worth the relatively small cost of doing them because they provide him with an excellent overview of the client’s operations. If the ratios are out of line, Morris discusses the reasons with the client and often make suggestions on how to bring the ratio back in line in the future. In some cases, these discussions with management have been the basis for management consulting engagements. Discuss the major strengths and shortcomings in Morris’s use of ratio and trend analysis.
: Roger Morris performs his ratio and trend analysis at the end of every audit. By that time, the audit procedures are completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings. SAS 56 (AU 329) requires that analytical procedures be performed in the planning phase of the audit and near the completion of the
audit.
The use of ratio and trend analysis appears to give Roger Morris an insight into his
client's business and affords him an opportunity to provide excellent business advice to his client.
24) Name the four categories of financial ratios and give an example of a ratio in each category. What is the primary information provided by each financial ratio category?
: The four categories of financial ratios and examples of ratios in each category are as follows:
1. Short-term debt-paying ability – Cash ratio, quick ratio, and current ratio.
2. Liquidity activity – Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory.
3. Ability to meet long-term debt obligations – Debt to equity and times interest earned.
4. Profitability – Earnings per share, gross profit percent, profit margin, return on
assets, and return on common equity
The Audit Process-Materiality and Risk
1) Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of materiality and risk?
: The planning phases are: accept client and perform initial planning, understand the client’s business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop overall audit plan and audit program. Evaluation of materiality is part of phase five. Risk assessment is part of phase three (client business risk), phase five (acceptable audit risk and inherent risk), phase six (control risk), and phase seven (fraud risk).
2) Define the meaning of the term materiality as it is used in accounting and auditing. What is the relationship between materiality and the phrase obtain reasonable assurance used in the auditor’s report?
: Materiality is defined as: the magnitude of an omission or misstatement of accounting information that, in light of the surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.
"Obtain reasonable assurance," as used in the audit report, means that the auditor does not guarantee or insure the fair presentation of the financial statements. There is some risk that the financial statements contain a material misstatement.
3) Explain why materiality is important but difficult to apply in practice.
: Materiality is important because if financial statements are materially misstated, users' decisions may be affected, and thereby cause financial loss to them. It is difficult to apply because there are often many different users of the financial statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materiality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guidance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment in the application of materiality.
4) What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment.
: The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows:
1. Materiality is a relative rather than an absolute concept.
2. Bases are needed for evaluating materiality.
3. Qualitative factors affect materiality decisions.
4. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the financial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower than if the financial statements are not expected to be widely distributed.
5. The level of acceptable audit risk will also affect the preliminary judgment of materiality.
5) What is meant by using bases for setting a preliminary judgment about materiality? How would those bases differ for the audit of a manufacturing company and a government unit such as school district?
: Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is no net income before taxes, and therefore that would be an unavailable base. Instead, the primary bases would likely be fund balances, total assets, and perhaps total revenue.
6) Assume that Rosanne Madden, CPA, is using 5% of net income before tax, current assets, or current liabilities as her major guidelines for
evaluating materiality. What qualitative factors should she also consider in deciding whether misstatements maybe material?
: The following qualitative factors are likely to be considered in evaluating materiality:
a. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts.
b. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations.
c. Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.
7) Distinguish between the terms tolerable misstatement and preliminary judgment about materiality. How are they related to each other?
: A preliminary judgment about materiality is set for the financial statements as a whole. Tolerable misstatement is the maximum amount of misstatement that would be considered material for an individual account balance. The amount of tolerable misstatement for any given account is dependent upon the preliminary judgment about materiality. Ordinarily, tolerable misstatement for any given account would have to be lower than the preliminary judgment about materiality. In many cases, it will be considerably lower because of the possibility of misstatements in different accounts that, in total, cannot exceed the preliminary judgment about materiality.
8) Assume a company with the following balance sheet accounts:
Account Amount
Cash $10,000
Fixed Assets $60,000
$70,000
Long-Term loans $30,000
M. Johnson Proprietor $40,000
$70,000
You are concerned only about overstatement of owner’s equity. Set tolerable misstatement for the three relevant accounts such that the preliminary judgment about materiality does not exceed $5,000. Justify your answer.
: There are several possible answers to the question. One example is:
Cash $500 Overstatement
Fixed assets $3,000 Overstatement
Long-term loans $1,500 Understatement
Note: Cash and fixed assets are tested for overstatement and long-term loans for understatement because the auditor's objective in this case is to test for overstatements of owner's equity.
The least amount of tolerable misstatement was allocated to cash and long-term loans because they are relatively easy to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of fixed assets in a typical audit.
9) Explain what is meant by making an estimate of the total misstatement in a segment and in the overall financial statements. Why is it important to make these estimates? What is done with them?
: An estimate of the total misstatement in a segment is the estimate of the total misstatements based upon the sample results. If only a sample of the population is selected and audited, the auditor must project the total sample misstatements to a total estimate. This is done audit area by audit area. The misstatements in each audit area must be totaled to make an estimate of the total misstatements in the overall financial statements. It is important to make these estimates so the auditor can evaluate whether the financial statements, taken as a whole, may be materially misstated. The estimate for each segment is compared to tolerable misstatement for that segment and the estimate of the overall misstatement on the financial statements is compared to the preliminary judgment about materiality.
10) How would the conduct of an audit of a medium-sized company be affected by the company’s being a small part of a large conglomerate as compared with it being a separate entity?
: If an audit is being performed on a medium-sized company that is part of a conglomerate, the auditor must make a materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomerate because even though the financial statements of the medium-sized company may be misstated, the financial statements of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the medium-sized company, the materiality would be lower than for the audit of a conglomerate.
11) Define the audit risk model and explain each term in the model.
: The audit risk model is as follows:
PDR = AAR
IR x CR
Where PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.
Acceptable audit risk A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.
Inherent risk A measure of the auditor's assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal control.
Control risk A measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client's internal controls.
12) What is meant by planned detection risk? What is the effect on the amount of evidence the auditor must accumulate when planned detection risk is increased from medium to high?
: Planned detection risk is a measure of the risk that the audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. When planned detection risk is increased from medium to high, the amount of evidence the auditor must accumulate is reduced.
13) Explain the causes of an increased or decreased planned detection risk.
: An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either control risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit risk or an increase in control risk or inherent risk.
14) Define what is meant by inherent risk. Identify four factors that make for high inherent risk in audits.
: Inherent risk is a measure of the auditor's assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal control.
Factors affecting assessment of inherent risk include:
Nature of the client's business
Results of previous audits
Initial vs. repeat engagement
Related parties
Non-routine transactions
Judgment required to correctly record transactions and
Makeup of the population
15) Explain why inherent risk is set for segments rather than for overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk is increased from medium to high for a segment? Compare your answer with the one for question 12.
: Inherent risk is set for segments rather than for the overall audit because misstatements occur in segments. By identifying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for misstatements in those segments.
When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to determine whether the expected misstatement actually occurs. The audit evidence goes in the opposite direction in Review Question 9-12.
16) Explain the effect of extensive misstatements found in the prior year’s audit on inherent risk, planned detection risk, and planned audit evidence.
: Extensive misstatements in the prior year's audit would cause inherent risk to be set at a high level (maybe even 100%). An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor increase the level of planned audit evidence.
17) Explain what is meant by term acceptable audit risk. What is its relevance to evidence accumulation?
: Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.
Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should increase.
18) Explain the relationship between acceptable audit risk and the legal liability of auditors.
: When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the acceptable audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is little exposure to legal liability, there is still a minimum acceptable audit risk that should be met.
19) State the three categories of factors that affect acceptable audit risk and list the factors that auditor can use to indicate the degree to which each category exists.
: The first category of factors that determine acceptable audit risk is the degree to which users rely on the financial statements. The following factors are indicators of this:
Client's size
Distribution of ownership
Nature and amount of liabilities
The second category of factors is the likelihood that a client will have financial difficulties after the audit report is issued. Factors affecting this are:
Liquidity position
Profits (losses) in previous years
Method of financing growth
Nature of the client's operations
Competence of management
The third category of factors is the auditor's evaluation of management's integrity.
Factors that may affect this are:
Relationship with current or previous auditors
Frequency of turnover of key financial or internal audit personnel
Relationship with employees and labor unions
20) Auditors have not been successful in measuring the components of the audit risk model. How is it possible to use the model in a meaningful way without a precise way of measuring risk?
: Exact quantification of all components of the audit risk model is not required to use the model in a meaningful way. An understanding of the relationships among model components and the
effect that changes in the components have on the amount of evidence needed will allow practitioners to use the audit risk model in a meaningful way.
21) Explain the circumstances when the auditor should revise the components of the audit risk model and the effect of the revisions on planned detection risk and planned evidence.
: The auditor should revise the components of the audit risk model when the evidence accumulated during the audit indicates that the auditor's original assessments of inherent risk or control risk are too low or too high or the original assessment of acceptable audit risk is too low or too high.
The auditor should exercise care in determining the additional amount of evidence that will be required. This should be done without the use of the audit risk model. If the audit risk model is used to determine a revised planned detection risk, there is a danger of not increasing the evidence sufficiently.
The Audit Process-Audits of Internal Control and Control Risk
1) Describe the three broad objectives management has when designing effective internal control.
: Management typically has three broad objectives in designing an effective internal control system.
1. Reliability of Financial Reporting Management is responsible for preparing financial statements for investors, creditors, and other users. Management has both a legal and professional responsibility to be sure that the information is fairly presented in accordance with reporting requirements such as GAAP. The objective of effective internal control over financial reporting is to fulfill these financial reporting responsibilities.
2. Efficiency and Effectiveness of Operations Controls within an organization are meant to encourage efficient and effective use of its resources to optimize the company’s goals. An important objective of these controls is accurate financial and non-financial information about the entity’s operations for decision making.
3. Compliance with Laws and Regulations Section 404 of the Sarbanes-Oxley Act requires all public companies to issue a report about the operating effectiveness of internal control over financial reporting. In addition to the legal provisions of Section 404, public,
nonpublic, and not-for-profit organizations are required to follow many laws and regulations. Some relate to accounting only indirectly, such as environmental protection and civil rights laws. Others are closely related to accounting, such as income tax regulations and fraud.
2) Describe which of the three categories of broad objectives for internal controls would be considered by the auditor in an audit of both financial statements and internal control over financial reporting.
: Management designs systems of internal control to accomplish three categories of objectives: financial reporting, operations, and compliance with laws and regulations. The auditor’s focus in both the audit of financial statements and the audit of internal controls is on those controls related to the reliability of financial reporting plus those controls related to operations and to compliance with laws and regulations objectives that could materially affect financial reporting.
3) Section 404 of the Sarbanes-Oxley Act requires management to issue a report on internal control over financial reporting. Identify the specific section 404 reporting requirements for management.
: Section 404 requires management of all public companies to issue an internal control report that includes the following:
A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting and
An assessment of the effectiveness of the internal control structure and procedures for financial reporting as of the end of the company’s fiscal year.
4) What two components of internal control must management assess when reporting on internal control to comply with section 404 of the Sarbanes-Oxley Act?
: Management’s assessment of internal control over financial reporting consists of two key components. First, management must evaluate the design of internal control over financial reporting. Second, management must test the operating effectiveness of those controls. When evaluating the design of internal control over financial reporting, management evaluates whether the controls are designed to prevent or detect material misstatements in the financial statements. When testing the operating effectiveness of those controls, the objective is to determine whether the control is operating as designed and whether the person performing the control possesses the necessary authority and qualifications to perform the control effectively.
5) Chapter eight introduced the eight parts of the planning phase of audits. Which part is understanding internal control and assessing control risk? What parts precede and follow that understanding and assessing?
: There are eight parts of the planning phase of audits: accept client and perform initial planning, understand the client’s business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop an overall audit plan and audit program. Understanding internal control and assessing control risk is therefore part six of planning. Only gathering information to assess fraud risk and developing an overall audit plan and audit program follow understanding internal control and assessing control risk.
6) What is the auditor’s responsibility for obtaining an understanding of internal control? How does the responsibility differ for audits of public and nonpublic companies?
: The second GAAS field work standard states “A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.” The auditor obtains the understanding of internal control to assess control risk in every audit and that responsibility is the same for audits of both public and nonpublic companies. Auditors are primarily concerned about controls related to the reliability of financial reporting and controls over classes of transactions.
7) When auditing a public company, what are the auditor’s responsibilities related to internal control as required by PCAOB standard 2?
: Section 404 requires that the auditor attest to and issue a report on management’s assessment of internal control over financial reporting. To express an opinion on internal controls, the auditor obtains an understanding of and performs tests of controls related to all significant account balances, classes of transactions, and disclosures and related assertions in the financial statements. PCAOB Standard 2 requires that the audit report on internal control over financial reporting under Sarbanes-Oxley include the auditor’s opinion as to whether management’s assessment of the design and operating effectiveness of internal control over financial reporting is fairly stated in all material respects. This involves both evaluating management’s assessment process and arriving at the auditor’s independent assessment of the internal controls’ design and operating effectiveness.
8) State the six transaction-related audit objectives.
: The six transaction-related audit objectives are:
1. Recorded transactions exist (existence).
2. Existing transactions are recorded (completeness).
3. Recorded transactions are stated at the correct amounts (accuracy).
4. Transactions are properly classified (classification).
5. Transactions are recorded on the correct dates (timing).
6. Recorded transactions are properly included in the master files and correctly summarized (posting and summarization).
9) Management must identify the framework used to evaluate the effectiveness of internal control over financial reporting. What framework is used by most U.S. public companies?
: COSO’s Internal ControlIntegrated Framework is the most widely accepted internal control framework in the U.S. The COSO framework describes internal control as consisting of five components that management designs and implements to provide reasonable assurance that its control objectives will be met. Each component contains many controls, but auditors concentrate on those designed to prevent or detect material misstatements in the financial statements.
10) What are the five components of internal control in the COSO internal control framework?
: The COSO Internal Control – Integrated Framework consists of the following five components:
1. Control environment
2. Risk assessment
3. Control activities
4. Information and communication
5. Monitoring
The control environment serves as the umbrella for the other four components. Without an effective control environment, the other four are unlikely to result in effective internal control, regardless of their quality.
11) What is meant by the control environment? What are the factors the auditor must evaluate to understand it?
: The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about internal control and its importance to the entity. The following are the most important subcomponents the control environment:
Integrity and ethical values
Commitment to competence
Board of directors or audit committee participation
Management's philosophy and operating style
Organizational structure
Assignment of authority and responsibility
Human resource policies and practices
12) What is the relationship among the five components of internal control?
: Internal control includes five categories of controls that management designs and implements to provide reasonable assurance that its control objectives will be met. These are called the components internal control, and are:
The control environment
Risk assessment
Control activities
Information and communication
Monitoring
The control environment is the broadest of the five and deals primarily with the way management implements its attitude about internal controls. The other four components are closely related to the control environment. Risk assessment is management's identification and analysis of risks relevant to the preparation of financial statements in accordance with GAAP. To respond to this risk assessment, management implements control activities and creates the accounting information and communication system to meet its objectives for
financial reporting. Finally, management periodically assesses the quality of internal control performance to determine that controls are operating as intended and that they are modified as appropriate for changes in conditions (monitoring).
13) List the types of specific control activities and provide one specific illustration of a control in sales area for each control activity.
: The five categories of control activities are:
Adequate separation of duties
Example: The following two functions are performed by different people: processing customer orders and billing of customers.
Proper authorization of transactions and activities
Example: The granting of credit is authorized before shipment takes place.
Adequate documents and records
Example: Recording of sales is supported by authorized shipping documents and approved customer orders.
Physical control over assets and records
Example: A password is required before entry into the computerized accounts receivable master file can be made.
Independent checks on performance
Example: Accounts receivable master file contents are independently verified.
14) The separation of operational responsibility from record keeping is meant to prevent different types of misstatements than the separation of the custody of assets from accounting. Explain the difference in the purposes of these two types of separation of duties.
: Separation of operational responsibility from record keeping is intended to reduce the likelihood of operational personnel biasing the results of their performance by incorrectly recording information.
Separation of the custody of assets from accounting for these assets is intended to prevent misappropriation of assets. When one person performs both functions, the possibility of that person's disposal of the asset for personal gain and adjustment of the records to relieve himself or herself of responsibility for the asset without detection increases.
15) For each of the following, give an example of a physical control the client can use to protect the asset or record:
1. Petty cash
2. Cash received by retail clerks
3. Accounts receivable records
4. Raw material inventory
5. Perishable tools
6. Manufacturing equipment
7. Marketable securities
: An example of a physical control the client can use to protect each of the following assets or records is:
1. Petty cash should be kept locked in a fireproof safe.
2. Cash received by retail clerks should be entered into a cash register to record all cash received.
3. Accounts receivable records should be stored in a locked, fireproof safe. Adequate backup copies of computerized records should be maintained and access to the master files should be restricted via passwords.
4. Raw material inventory should be retained in a locked storeroom with a reliable and competent employee controlling access.
5. Perishable tools should be stored in a locked storeroom under control of a reliable employee.
6. Manufacturing equipment should be kept in an area protected by burglar alarms and fire alarms and kept locked when not in use.
7. Marketable securities should be stored in a safety deposit vault.
16) Explain what is meant by independent checks on performance and give five specific examples.
: Independent checks on performance are internal control activities designed for the continuous internal verification of other controls. Examples of independent checks include:
Preparation of the monthly bank reconciliation by an individual with no responsibility for recording transactions or handling cash.
Re-computing inventory extensions for a listing of inventory by someone who did not originally do the extensions.
The preparation of the sales journal by one person and the accounts receivable master file by a different person, and a reconciliation of the control account to the master file.
The counting of inventory by two different count teams.
The existence of an effective internal audit staff.
17) Describe the four phases performed by the auditor when obtaining an understanding of internal control and assessing control risk.
: As illustrated by Figure 10-3, there are four phases in the process of understanding internal control and assessing control risk. In the first phase the auditor obtains an understanding of internal controls. Next the auditor must make a preliminary assessment control risk (phase 2) and perform tests of controls in every audit as part of their integrated audits (phase 3). The auditor uses the results of tests of controls for both the audit report on internal control over financial reporting and to assess control risk and to ultimately decide planned detection risk and substantive tests for the audit of financial statements, which is phase 4.
18) What are management’s responsibilities for documenting internal control over financial reporting in a public company? How would the lack of documentation affect an auditor’s report on internal control over financial reporting by PCAOB standard 2?
: Section 404 of the Sarbanes-Oxley Act requires management to document its processes for assessing the effectiveness of the company’s internal control over financial reporting. Management must document the design of controls, including all five control components and also the results of its testing and evaluation. The types of information gathered by management to assess and document internal control effectiveness can take many forms, including policy manuals, flowcharts, narratives, documents, questionnaires and other forms that are in either paper or electronic formats. PCAOB Standard 2 requires the auditor to evaluate the client’s documentation when auditing internal control over financial reporting. The lack of management documentation of internal control over financial reporting may prevent the auditor from concluding that the controls are adequately designed or operating effectively. When documentation is inadequate, the auditor may decide to withdraw from the engagement or to issue a disclaimer of opinion on internal control over financial reporting.
19) What two aspects of internal control must the auditor assess when performing procedures to obtain an understanding of internal control?
: When obtaining an understanding of internal control, the auditor must assess two aspects about those controls. First, the auditor must gather evidence about the design of internal controls. Second, the auditor must gather evidence about whether those controls have been placed in operation.
20) What is a walkthrough of internal control? What is the PCAOB standard 2 requirement related to auditor walkthroughs of internal control in an integrated audit?
: In a walkthrough of internal control, the auditor selects one or a few documents for the initiation of a transaction type and traces them through the entire accounting process. At each stage of processing, the auditor makes inquiries and observes current activities, in addition to examining completed documentation for the transaction or transactions selected. Thus, the auditor combines observation, documentation, and inquiry to conduct a walkthrough of internal control. PCAOB Standard 2 requires the auditor to perform at least one walkthrough for each major class of transactions.
21) Describe what is meant by a key control and a control deficiency.
: A key control is a control that is expected to have the greatest effect on meeting the transaction-related audit objectives. A control deficiency represents a deficiency in the design or operation of controls that does not permit company personnel to prevent or detect misstatements on a timely basis. A design deficiency exists if a necessary control is missing or not properly designed. An operation deficiency exists if a well designed control does not operate as designed or when the person performing the control is insufficiently qualified or authorized.
22) Distinguish a significant deficiency in internal control form a material weakness in internal control. How would the presence of one significant deficiency affect the auditor’s report on internal control required by PCAOB standard 2? How would the presence of one material weakness affect an auditor’s report on internal control required by PCAOB standard 2?
: A significant deficiency exists if one or more control deficiencies exist that, more than remotely, adversely affect a company’s ability to initiate, authorize, record, process, or report external financial statements reliably. A material weakness exists if a significant deficiency, by itself, or in combination with other significant deficiencies, results in a more than remote likelihood that internal control will not prevent or detect material financial statement misstatements. The presence of one significant deficiency that is not deemed to be a material weakness may not affect the auditor’s report. In that instance, the auditor’s report on internal control over financial reporting would contain an unqualified opinion. However, if the deficiency is deemed to be a material weakness, the auditor must express an adverse opinion on the effectiveness of internal control over financial reporting.
23) Frank James, a highly competent employee of Brinkwater Sales Corporation, had been responsible for accounting-related matters for two decades. His devotion to the firm and his duties always been exceptional, and over the years, he had been given increased responsibility. Both president of Brinkwater and the partner of an independent CPA firm in charge of the audit were shocked and dismayed to discover that James had embezzled more than $500,000 over a 10-year period by not recording billings in the sales journal and subsequently diverting the cash receipts. What major factors permitted the defalcation to take place?
: The most important internal control deficiency which permitted the defalcation to occur was the failure to adequately segregate the accounting responsibility of recording billings in the sales journal from the custodial responsibility of receiving the cash. Regardless of how trustworthy James appeared, no employee should be given the combined duties of custody of assets and accounting for those assets.
24) Jeanne Maier, CPA, believes that it is appropriate to obtain an understanding of intaernal control about halfway through the audit, after she is familiar with the client’s operations and the way the system actually works. Sha has found through experience taht filling out internal control questionnaires and flowcharts early in the engagement is not beneficial because the system rarely functions the way it is supposed to. Later in engagement, the auditor can prepare flowcharts and questionnaires with relative ease because of the knowledge already obtained on the audit. Evaluate her approach.
: Maier is correct in her belief that internal controls frequently do not function in the manner they are supposed to. However, regardless of this, her approach ignores the value of beginning
the understanding of internal control by preparing or reviewing a rough flowchart. Obtaining an early understanding of the client's internal control will provide Maier with a basis for a decision about the audit procedures and sample sizes based on assessed control risk. By not obtaining an understanding of internal control until later in the engagement, Maier risks performing either too much or too little work, or emphasizing the wrong areas during her audit.
25) Distinguish the auditor’s responsibility for testing control in an audit of a public company from the responsibility to test controls in an audit of a nonpublic company.
: The extent of controls tested by auditors to express an opinion on internal controls for a public company is significantly greater than that tested solely to express an opinion on the financial statements. To express an opinion on internal controls for a public company, the auditor obtains an understanding of and performs tests of controls for all significant account balances, classes of transactions, and disclosures and related assertions in the financial statements. In contrast, the extent of controls tested by an auditor of a nonpublic company is dependent on the auditor’s assessment of control risk. Whenever the auditor assesses control risk below maximum, the auditor must perform tests of controls to support that control risk assessment. The auditor will not perform tests of controls when the auditor assesses control risk at maximum, either because of inadequate controls or because it is inefficient to test those controls. When control risk is assessed below the maximum, the auditor designs and performs a combination of tests of controls and substantive procedures. Thus, for a nonpublic company, the tests of controls vary based on the auditor’s assessment of control risk.
26) How does the sufficiency of evidence differ between procedures to obtain an understanding of internal control and tests of controls?
: There is a significant overlap between tests of controls and procedures to obtain an understanding of internal control. Both include inquiry, documentation, and observation. There are two primary differences in the application of these common procedures. First, in obtaining an understanding of internal control, the procedures to obtain an understanding are applied to all controls identified during that phase. Tests of controls, on the other hand, are applied only when the assessed control risk has not been satisfied by the procedures to obtain an understanding. Second, procedures to obtain an understanding are performed only on one or a few transactions or, in the case of observations, at a single point in time. Tests of controls are performed on larger samples of transactions (perhaps 20 to 100), and often observations are made at more than one point in time.
27) During the prior-year audits of McKimmon Inc., a public company, the auditor did tests of controls for all relevant financial statement assertions. Some of the related controls are manual while others are automated. Describe the extent the auditor can rely on tests of controls performed in prior years.
: PCAOB Standard 2 requires a public company auditor to test controls each year for all relevant assertions for significant accounts and transactions. However, if evidence was obtained in the prior year’s audit that indicates that a key control was operating effectively, and the auditor determines that the control is still in place, the extent of the tests of that control may be reduced somewhat in the current year.
28) What are two opinions that must be included in the auditor’s report on internal control over financial reporting required by PCAOB standard 2?
: PCAOB Standard 2 requires that the auditor’s report on internal control include two auditor opinions:
1. The auditor’s opinion on whether management’s assessment of the effectiveness of internal control over financial reporting as of the end of the fiscal period is fairly stated, in all material respects. In practice it is unlikely for the auditor to issue anything other than an unqualified report on this opinion. If the auditor concludes that management has not identified and reported all significant deficiencies and
material weaknesses, it will be in management’s best interests to revise its report to conform to the auditor’s conclusions.
2. The auditor’s opinion on whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date. There is likely to be more variety in these reports.
29) What two conditions must be present for the auditor to issue an unqualified opinion on internal control over financial reporting? What type of condition will cause the auditor to issue a qualified or disclaimer of opinion on internal control over financial reporting?
: The auditor may issue an unqualified opinion on internal control over financial reporting when two conditions are present:
there are no identified material weaknesses; and
there have been no restrictions on the scope of the auditor’s work.
A scope limitation is the condition that would cause the auditor to express a qualified opinion or a disclaimer of opinion on internal control over financial reporting. This type of opinion is issued when the auditor is unable to determine if there are material weaknesses, due to a restriction on the scope of the audit of internal control over financial reporting or other circumstances where the auditor is unable to obtain sufficient evidence.
30) Describe the concept of an integrated audit of the financial statements and internal control required by PCAOB standard 2.
: PCAOB Standard 2 requires that the audit of the financial statements and the audit of internal control over financial reporting be integrated. In an integrated audit, the auditor must consider the results of audit procedures performed to issue the audit report on the financial statements when issuing the audit report on internal control. For example, if the auditor identifies a material misstatement in the financial statements that was not initially identified by the company’s internal controls, the auditor should consider this as at least a significant deficiency, if not a material weakness for purposes of reporting on internal control. In such circumstances, the auditor’s report on the financial statements may be unqualified as long as management corrected the misstatement before issuing the financial statements. In contrast, however, the auditor’s report on internal control must include an adverse opinion if the auditor concludes it is a material weakness.
The Audit Process-Fraud Auditing
1) Define fraudulent financial reporting and give two examples that illustrate fraudulent financial reporting.
: Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. Two examples of fraudulent financial reporting are accelerating the timing of recording sales revenue to increased reported sales and earnings, and recording expenses as fixed assets to increase earnings.
2) Define misappropriation of assets and give two examples of misappropriation of assets.
: Misappropriation of assets is fraud that involves theft of an entity’s assets. Two examples are an accounts payable clerk issuing payments to a fictitious company controlled by the clerk, and a sales clerk failing to record a sale and pocketing the cash receipts.
3) Distinguish fraudulent financial reporting from misappropriation of assets.
: Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users, while misappropriation of assets is fraud that involves theft of an entity’s assets. Frauds involving financial reporting are usually larger than frauds involving misappropriation of assets, usually involve top management, and do not directly involve theft of company assets.
4) What are the three conditions of fraud often referred to as “the fraud triangle?”
: The three conditions of fraud referred to as the “fraud triangle” are (1) Incentives/Pressures;
(2) Opportunities; and (3) Attitudes/Rationalization. Incentives/Pressures are incentives of management or other employees to commit fraud. Opportunities are circumstances that allow management or employees to commit fraud. Attitudes/Rationalization are indications that an attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
5) Give examples of risk factors for fraudulent financial reporting for each of the three fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization.
: The following are example of risk factors for fraudulent financial reporting for each of the three fraud conditions:
Incentives/Pressures - The company is under pressure to meet debt covenants or obtain additional financing.
Opportunities – Ineffective oversight of financial reporting by the board of directors allows management to exercise discretion over reporting.
Attitudes/Rationalization – Management is overly aggressive. For example, the company may issue aggressive earnings forecasts, or make extensive acquisitions using company stock.
6) Give examples of risk factors for misappropriation of assets for each of the three fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization.
: The following are example of risk factors for misappropriation of assets for each of the three fraud conditions:
Incentives/Pressures - The individual is unable to meet personal financial obligations.
Opportunities – There is insufficient segregation of duties that allows the individual to handle cash receipts and related accounting records.
Attitudes/Rationalization – Management has disregarded the inadequate separation of duties that allows the potential theft of cash receipts.
7) What sources are used by the auditor to gather information to assess fraud risks?
: Auditors use several sources to gather information about fraud risks, including:
Information obtained from communications among audit team members about their knowledge of the company and its industry, including how and where the company might be susceptible to material misstatements due to fraud.
Responses to auditor inquiries of management about their views of the risks of fraud and about existing programs and controls to address specific identified fraud risks.
Specific risk factors for fraudulent financial reporting and misappropriations of assets.
Analytical procedures results obtained during planning that indicate possible implausible or unexpected analytical relationships.
Knowledge obtained through other procedures such as client acceptance and retention decisions, interim review of financial statements, and consideration of inherent or control risks.
8) What should the audit team consider in its planning discussion about fraud risks?
: SAS 99 requires the audit team to conduct discussions to share insights from more experienced audit team members and to “brainstorm” ideas that address the following:
1. How and where they believe the entity’s financial statements might be susceptible to material misstatement due to fraud. This should include consideration of known external and internal factors affecting the entity that might
create an incentive or pressure for management to commit fraud.
provide the opportunity for fraud to be perpetrated.
indicate a culture or environment that enables management to rationalize fraudulent acts.
2. How management could perpetrate and conceal fraudulent financial reporting.
3. How assets of the entity could be misappropriated.
4. How the auditor might respond to the susceptibility of material misstatements due to fraud.
9) Auditors are required to make inquiries of individuals in the company when gathering information to asses fraud risk. Identify those with whom the auditor must make inquiries.
: Auditors must inquire whether management has knowledge of any fraud or suspected fraud within the company. SAS 99 also requires auditors to inquire of the audit committee about its views of the risks of fraud and whether the audit committee has knowledge of any fraud or suspected fraud. If the entity has an internal audit function, the auditor should inquire about internal audit’s views of fraud risks and whether they have performed any procedures to identify or detect fraud during the year. SAS 99 further requires the auditor to make inquiries of others within the entity whose duties lie outside the normal financial reporting lines of responsibility about the existence or suspicion of fraud.
10) Describe the purpose of corporate codes of conduct and identify three examples of items addressed in a typical code of conduct.
: The corporate code of conduct establishes the “tone at the top” of the importance of honesty and integrity and can also provide more specific guidance about permitted and prohibited behavior. Example of items typically addressed in a code of conduct include expectations of general employee conduct, restrictions on conflicts of interest, and limitations on relationships with clients and suppliers.
11) Discuss the importance of the control environment, or “setting the tone at the top,” in establishing a culture of honesty and integrity in a company.
: Management and the board of directors are responsible for setting the “tone at the top” for ethical behavior in the company. It is important for management to behave with honesty and integrity because this reinforces the importance of these values to employees throughout the organization.
12) Distinguish management’s responsibility from the audit committee’s responsibility for designing and implementing antifraud programs and controls within a company.
: Management has primary responsibility to design and implement antifraud programs and controls to prevent, deter, and detect fraud. The audit committee has primary responsibility to oversee the organization’s financial reporting and internal control processes and to provide oversight of management’s fraud risk assessment process and antifraud programs and controls.
13) What are the three categories of auditor responses to fraud risks?
: The three auditor responses to fraud are: (1) change the overall conduct of the audit to respond to identified fraud risks; (2) design and perform audit procedures to address identified risks; and (3) perform procedures to address the risk of management override of controls.
14) What three auditor actions are required to address the potential for management override of controls?
: Auditors are required to take three actions to address potential management override of controls: (1) examine journal entries and other adjustments for evidence of possible misstatements due to fraud; (2) review accounting estimates for biases; and (3) evaluate the business rationale for significant unusual transactions.
15) Describe the three main techniques used to manipulate revenue.
: Three main techniques use to manipulate revenue include: (1) recording of fictitious revenue; (2) premature revenue recognition including techniques such as bill-and-hold sales and channel stuffing; and (3) manipulation of adjustments to revenue such as sales returns and allowance and other contra accounts.
16) You go through the drive-through window of a fast food restaurant and notice a sign that reads “your meal is free if we fail to give you a receipt.” Why would the restaurant post this sign?
: Cash register receipts are particularly susceptible to theft. The notice “your meal is free if we fail to give you a receipt” is designed to ensure that every customer is given a receipt and all sales are entered into the register, establish accountability for the sale.
17) Name the three categories of inquiry and describe the purpose of each when used by an auditor to obtain additional information about a suspected fraud.
: The three types of inquiry are informational, assessment, and interrogative. Auditors use informational inquiry to obtain information about facts and details that the auditor does not have. For example, if the auditor suspects financial statement fraud involving improper revenue recognition, the auditor may inquire of management as to revenue recognition policies. The auditor uses assessment inquiry to corroborate or contradict prior information. In the previous example, the auditor may attempt to corroborate the information obtained from management by making assessment inquiries of individuals in accounts receivable and shipping. Interrogative inquiry is used to determine if the interviewee is being deceptive or purposefully omitting disclosure of key knowledge of facts, events, or circumstances. For example, a senior member of the audit team might make interrogative inquiries of management or other personnel about key elements of the fraud where earlier responses were contradictory or evasive.
18) Identify three verbal and three nonverbal cues that may be observed when making inquiries of an individual who is being deceitful.
: When making inquiries of a deceitful individual, three examples of verbal cues are frequent rephrasing of the question, filler terms such as “well” or “to tell the truth,” and forgetfulness or acknowledgements of nervousness. Three examples of nonverbal cues by the individual are
creating physical barriers by blocking their mouth, leaning away from the auditor, and signs of stress such as sweating or fidgeting.
19) You have identified a suspected fraud involving the company’s controller. What must you do in response to this discovery? How might this discovery affect your report on internal control when auditing a public company?
: When the auditor suspects that fraud may be present, SAS 99 requires the auditor to obtain additional evidence to determine whether material fraud has occurred. SAS 99 also requires the auditor to consider the implications for other aspects of the audit. When the auditor determines that fraud may be present, SAS 99 requires the auditor to discuss the matter and audit approach for further investigation with an appropriate level of management that is at least one level above those involved, and with senior management and the audit committee, even if the matter might be considered inconsequential. For public company auditors, the discovery of fraud of any magnitude by senior management is at least a significant deficiency and may be a material weakness in internal control over financial reporting. This includes fraud by senior management that results in even immaterial misstatements. If the public company auditor decides the fraud is a material weakness, the auditor’s report on internal control over financial reporting will contain an adverse opinion.
The Audit Process-The Impact of Information Technology
1) Explain how client internal controls can be improved through the proper installation of IT.
: The proper installation of IT can lead to internal control enhancements by replacing manually- performed controls with computer-performed controls. IT-based accounting systems have the ability to handle tremendous volumes of complex business transactions cost effectively. Computer-performed controls can reduce the potential for human error by replacing manual controls with programmed controls that apply checks and balances to each transaction processed. The systematic nature of IT offers greater potential to reduce the risk of material misstatements resulting from random, human errors in processing.
The use of IT based accounting systems also offers the potential for improved management decisions by providing more and higher quality information on a more timely basis than traditional manual systems. IT-based systems are usually administered effectively because the complexity requires effective organization, procedures, and documentation. That in turn enhances internal control.
2) Identify risks for accounting systems that rely heavily on IT functions.
: When entities rely heavily on IT systems to process financial information, there are new risks specific to IT environments that must be considered. Key risks include the following:
Reliance on the functioning capabilities of hardware and software. The risk of system crashes due to hardware or software failures must be evaluated when entities rely on IT to produce financial statement information.
Visibility of audit trail. The use of IT often converts the traditional paper trail to an electronic audit trail, eliminating source documents and paper-based journals and records.
Reduced human involvement. The replacement of traditional manual processes with computer-performed processes reduces opportunities for employees to recognize misstatements resulting from transactions that might have appeared unusual to experienced employees.
Systematic versus random errors. Due to the uniformity of processing performed by IT based systems, errors in computer software can result in incorrect processing for all transactions processed. This increases the risk of many significant misstatements.
Unauthorized access. The centralized storage of key records and files in electronic form increases the potential for unauthorized on-line access from remote locations.
Loss of data. The centralized storage of data in electronic form increases the risk of data loss in the event the data file is altered or destroyed.
Reduced segregation of duties. The installation of IT-based accounting systems centralizes many of the traditionally segregated manual tasks into one IT function.
Lack of traditional authorization. IT-based systems can be programmed to initiate certain types of transactions automatically without obtaining traditional manual approvals.
Need for IT experience. As companies rely to a greater extent on IT-based systems, the need for personnel trained in IT systems increases in order to install, maintain, and use systems.
3) Define what is meant by an audit trail and explain how it can be affected by client’s integration of IT.
: The audit trail represents the accumulation of source documents and records maintained by the client to serve as support for the transactions occurring during the accounting period. The integration of IT can change the audit trail by converting many of the traditionally paper-based source documents and records into electronic files that cannot be visually observed. Because many of the transactions are entered directly into the computer as they occur, some of the documents and records are even eliminated.
4) Distinguish between random error resulting from manual processing and systematic error resulting from IT processing and give an example of each category of error.
: Random error represents errors that occur in an inconsistent pattern. Manual accounting systems are especially prone to random errors that result from honest mistakes that occur as employees perform day-to-day tasks. When those mistakes do not consistently occur while performing a particular task, errors are distributed randomly into the accounting records. An example of a random error is when an employee accidentally pulls the wrong unit price off the approved price list when preparing a sales invoice for a particular customer.
Systematic error represents errors that occur consistently across all similar transactions. Because IT-based systems perform tasks uniformly for all transactions submitted, any mistake in software programming results in the occurrence of the same error for every transaction processed by the system. An example of a systematic error occurs when a program that is supposed to post sales amounts to the accounts receivable subsidiary records actually posts the sales amount twice to customers’ accounts.
5) Identify the traditionally segregated duties in noncomplex IT systems and explain how increases in the complexity of the IT function affect that separation.
: In most traditional accounting systems, the duties related to authorization of transactions, recordkeeping of transactions, and custody of assets are segregated across three or more individuals. As accounting systems make greater use of IT, many of the traditional manually performed tasks are now performed by the computer. As a result, some of the traditionally segregated duties, particularly authorization and recordkeeping, fall under the responsibility of IT personnel. To compensate for the collapsing of duties under the IT function, key IT tasks related to programming, operation of hardware and software, and data control are segregated. Separation of those IT functions restricts an IT employee’s ability to inappropriately access software and data files in order to misappropriate assets.
6) Distinguish between general controls and application controls and give two examples of each.
: General controls relate to all aspects of the IT function. They have a global impact on all software applications. Examples of general controls include controls related to the administration of the IT function; software acquisition and maintenance; physical and on-line security over access to hardware, software, and related backup; back-up planning in the event of unexpected emergencies; and hardware controls. Application controls apply to the processing of individual transactions. An example of an application control is a programmed control that verifies that all time cards submitted are for valid employee id numbers included in the employee master file.
7) Identify the typical duties within an IT function and describe how those duties should be segregated among IT personnel.
: The typical duties often segregated within an IT function include systems development, computer operations, and data control. Systems development involves the acquisition or programming of application software. Systems development personnel work with test copies of programs and data files to develop new or improved application software programs. Computer operations personnel are responsible for executing live production jobs in accordance with a job schedule and for monitoring consoles for messages about computer efficiency and malfunctions. Data control personnel are responsible for data input and output control. They often independently verify the quality of input and the reasonableness of output. By separating these functions, no one IT employee can make changes to application software or underlying master files and then operate computer equipment to use those changed programs or data files to process transactions.
8) Explain how the effectiveness of general controls affects the auditor’s tests of automated application controls, including the auditor’s ability to rely on tests done in prior audits.
: If general controls are ineffective, there is a potential for material misstatement in each computer-based accounting application, regardless of the quality of application controls. If, for example, the systems development process is not properly controlled, there is a greater risk that unauthorized and untested modifications to accounting applications software have occurred. If general controls are strong, there is a greater likelihood of placing greater reliance on application controls. Stronger general controls should lead to greater likelihood that underlying applications operate effectively and data files contain accurate, authorized, and complete information.
9) Explain the relationship between application controls and transaction-related audit objectives.
: Application controls apply to the processing of specific individual transactions within a transaction cycle, such as a computer performed credit approval process for sales on account. Due to the nature of these types of controls, application controls generally link directly to one or more specific transaction objectives. For example, the credit approval application control directly links to the existence objective for sales. Auditors typically identify both manual and computer-
performed application controls for each transaction-related objective using a control risk matrix similar to the one discussed in Chapter 10.
10) Explain what is meant by auditing around the computer and describe what must be present for this approach to be effective when auditing clients who use IT to process accounting information.
: “Auditing around the computer” represents an audit approach whereby the auditor does not use computer controls to reduce control risk. Instead, the auditor uses non-IT controls to support a reduced control risk assessment. In these situations, the use of IT does not significantly impact the audit trail. Typically, the auditor obtains an understanding of internal control and performs tests of controls, substantive tests of transactions, and account balance verification procedures in the same manner as if the accounting system was entirely manual. The auditor is still responsible for gaining an understanding of general and application computer controls because such knowledge is useful in identifying risks that may affect the financial statements.
11) Explain what is meant by the test data approach. What are the major difficulties with using this approach? Define parallel simulation with audit software and provide an example of how it can be used to test a client’s payroll system.
: The test data approach involves processing the auditor’s test data using the client’s computer system and the client’s application software program to determine whether the computer- performed controls correctly process the test data. Because the auditor designs the test data, the auditor is able to identify which test items should be accepted or rejected by the computer. When using this approach the auditor should assess the following:
How effectively does the test data represent all relevant conditions that the auditor wants to test?
How certain is the auditor that the application programs being tested by the auditor’s test data are the same programs as those used by the client throughout the year to process actual transactions?
How certain is the auditor that test data is effectively eliminated from the client’s records once testing is completed?
Parallel simulation with audit software involves the auditor’s use of an auditor-controlled software program to perform parallel operations to the client’s software by using the same data files. Because the auditor’s software is designed to parallel an operation performed by the client’s software, this strategy is referred to as parallel simulation testing. Parallel simulation could be used in the audit of payroll by writing a program that calculates the accrued vacation pay liability for each employee using information contained in the employee master file. The total liability calculated by the auditor’s software program would then be compared to the client’s calculation to determine if the liability for accrued vacation pay is fairly stated at year-end.
12) Describe risks that are associated with purchasing software to be installed on microcomputer hard drives. What precautions can clients take to reduce those risks?
: Often companies that purchase and install vendor developed software applications on computer hard drives rely on IT consultants to assist in the installation and maintenance of that software because those companies do not have dedicated IT personnel. Also, assignment of responsibility may reside with user departments. Companies can reduce these risks related to not having IT personnel by performing sufficient reference and background checks about software vendor and IT consultant reputations. In addition, companies can load software programs onto hard drives in a format that does not permit changes by client personnel, particularly non-IT user department personnel who may have primary responsibility for the system. Companies should also consider segregating key duties related to access to master files and responsibilities for processing transactions.
13) Compare the risks associated with network systems to those associated with centralized IT functions.
: Because many companies that operate in a network environment decentralize their network servers across the organization, there is an increased risk for a lack of security and lack of overall management of the network operations. The decentralization may lead to a lack of standardized equipment and procedures. In many instances responsibility for purchasing equipment and software, maintenance, administration, and physical security, often resides with key user groups rather than with a centralized IT function. Also, network-related software often lacks the security features, including segregation of duties, typically available in traditionally centralized environments because of the ready access to software and data by multiple users.
14) How does the use of a database management system affect risks?
: In database management systems, many applications share the same data files. This increases risks in some cases given that multiple users, including individuals outside accounting, access and update data files. Without proper database administration and access controls, risks of unauthorized, inaccurate, and incomplete data files increase. The centralization of data also increases the need to properly back-up data information on a regular basis.
15) An audit client is in the process of creating an online web-based sales ordering system for customers to purchase products using personal credit cards for payment. Identify three risks related to an online sales system that management should consider. For each risk, identify an internal control that could be implemented to reduce that risk.
: An online sales ordering system poses many potential risks for an audit client. Risks that may exist include:
1. Customer data is susceptible to interception by unauthorized third parties.
2. The client company’s data, programs, and hardware are susceptible to potential interception or sabotage by external parties.
3. An unauthorized third party may attempt to transact business with the client company.
These risks can be addressed by the use of firewalls, encryption techniques, and digital signatures. A firewall is a system of hardware and software that monitors and controls the flow of e-commerce communications by channeling all network connections through a control gateway. A firewall protects data, programs, and other IT resources from external users accessing the system through networks, such as the Internet. Encryption techniques are based on computer programs that transform a standard message into a coded (encrypted) form. One key (the public key) is used for encoding the message and the other key (the private key) is used to decode the message. Encryption techniques protect the security of electronic communication during the transmission process. Finally, the use of digital signatures can enhance internal controls over the online sales order system by authenticating the validity of customers and other trading partners who conduct business with the client company.
16) Explain why it is unacceptable for an auditor to assume that an independent computer service center is providing reliable accounting information to an audit client. What can auditor do to test the service center’s internal controls?
: It is unacceptable for an auditor to assume an independent computer service center is providing reliable accounting information to an audit client because the auditor has no firsthand knowledge as to the adequacy of the service center’s controls. If the client’s service center
application is involved in processing significant financial data, the auditor must consider the need to obtain an understanding of internal control and test the service center’s controls.
The auditor can test the service center’s system by use of the test data and other tests of controls. Or, he or she may request that the service center auditor obtain an understanding and test controls of the service center, which are summarized in a special report issued by the service center auditor for use by the customer’s auditor.
The Audit Process-Overall Audit Plan and Audit Program
1) What are the five types of tests auditors use to determine whether financial statements are fairly stated? Identify which tests are performed to reduce control risk and which tests are performed to reduce planned detection risk. Also, identify which tests will be used by a public company auditor when internal control over financial reporting.
: The five types of tests auditors use to determine whether financial statements are fairly stated include the following:
Procedures to gain an understanding of internal control
Tests of controls
Substantive tests of transactions
Analytical procedures
Tests of details of balances
While procedures to gain an understanding of internal control help the financial statement auditor obtain information to make an initial assessment of control risk, tests of controls must be performed as support of an assessment of control risk that is below maximum. The purpose of tests of controls is to obtain evidence regarding the effectiveness of controls, which may allow the auditor to assess control risk below maximum. If controls are found to be effective and functioning, the substantive evidence may be reduced. Substantive evidence is obtained to reduce detection risk. Substantive evidence includes evidence from substantive tests of transactions, analytical procedures, and tests of details of balances.
For audits of internal control over financial reporting, the auditor only performs the first two types of audit tests: procedures to obtain an understanding of internal control and tests of controls. Because a public company auditor must issue a report on internal control over financial reporting, the extent of the auditor’s tests of controls must be sufficient to issue an opinion about
the operating effectiveness of those controls. That generally requires a significant amount of testing of controls over financial reporting.
2) What is the purpose of tests of controls? Identify specific accounts on the financial statements that are affected by performing tests of controls for the acquisition and payment cycle.
: Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in support of a reduced assessed control risk. Tests of controls provide the primary basis for a public company auditor’s report on internal controls over financial reporting. Specific accounts affected by performing tests of controls for the acquisition and payment cycle include the following: cash, accounts payable, purchases, purchase returns and allowances, purchase discounts, manufacturing expenses, selling expenses, prepaid insurance, leasehold improvements, and various administrative expenses.
3) Distinguish between a test of control and a substantive test of transactions. Give two examples of each.
: Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in support of a reduced assessed control risk. Examples include:
1. The examination of vendor invoices for indication that they have been clerically tested, compared to a receiving report and purchase order, and approved for payment.
2. Examination of employee time cards for approval of overtime hours worked.
3. Examination of journal entries for proper approval.
4. Examination of approvals for the write-off of bad debts.
Substantive tests of transactions are audit procedures testing for monetary misstatements to determine whether the six transaction-related audit objectives have been satisfied for each class of transactions. Examples are:
1. Recalculation of amounts (quantity times unit selling price) on selected sales invoices and tracing of amounts to the sales journal.
2. Examination of vendor invoices in support of amounts recorded in the acquisitions journal for purchases of inventories.
3. Recalculation of gross pay for selected entries in the payroll journal.
4. Tracing of selected customer cash receipts to the accounts receivable master file, agreeing customer names and amounts.
4) State a test of control audit procedure to test the effectiveness of the following control: approved wage rates are used in calculating employees’ earnings. State a substantive test of transactions audit procedure to determine whether approved wage rates are actually used in calculating employees’ earnings.
: A test of control audit procedure to test that approved wage rates are used to calculate employees' earnings would be to examine rate authorization forms to determine the existence of authorized signatures.
A substantive test of transactions audit procedure would be to compare a sample of rates actually paid, as indicated in the earnings record, to authorized pay rates on rate authorization forms.
5) A considerable portion of the tests of controls and substantive tests of transactions are performed simultaneously as a matter of audit convenience. But the substantive tests of transactions procedures and sample size, in part, depend on the results of the tests of controls. How can the auditor resolve this apparent inconsistency?
: The auditor resolves the problem by making assumptions about the results of the tests of controls and performing both the tests of controls and substantive tests of transactions on the basis of these assumptions. Ordinarily the auditor assumes an effective system of internal control with few or no exceptions planned. If the results of the tests of controls are as good as or better than the assumptions that were originally made, the auditor can be satisfied with the substantive tests of transactions, unless the substantive tests of transactions themselves indicate the existence of misstatements. If the tests of controls results were not as good as the auditor assumed in designing the original tests, expanded substantive tests must be performed.
6) Evaluate the following statement: “tests of sales and cash receipts transactions are such an essential part of every audit that i like to perform them as near the end of the audits as possible. By that time i have a fairly good understanding of the client’s business and its internal controls because confirmations, cutoff tests, and other procedures have already been completed.”
: The primary purpose of testing sales and cash receipts transactions is to evaluate the internal controls so that the scope of the substantive tests of the account balances may be set. If the auditor performs the tests of details of balances prior to testing internal controls, no benefit will be derived from the tests of controls. The auditor should attempt to understand the client's business and internal controls as early as practical through the analysis of the accounting system, tests of controls, and substantive tests of transactions.
7) Explain how the calculation and comparison to previous years of the gross margin percentage and the ratio of accounts receivable to sales are related to the confirmation of accounts receivable and other tests of the accuracy of accounts receivable.
: When the results of analytical procedures are different from the auditor's expectations and thereby indicate that there may be a misstatement in the balance in accounts receivable or sales, the auditor should extend the tests to determine why the ratios are different from expectations. Confirmation of accounts receivable and cutoff tests for sales are two procedures that can be used to do this. On the other hand, if the ratios are approximately what the auditor expects, the other tests can be reduced. This means that the auditor can satisfy the evidence requirements in different ways and that analytical procedures and confirmation are complementary when the results of the tests are both good.
8) Distinguish between substantive tests of transactions and tests of details of balances. Give one example of each for the acquisition and payment cycle.
: Substantive tests of transactions are performed to verify the accuracy of a client's accounting system. This is accomplished by determining whether individual transactions are correctly recorded and summarized in the journals, master files, and general ledger. Substantive tests of transactions are also concerned with classes of transactions, such as payroll, acquisitions, or cash receipts. Tracing amounts from a file of vouchers to the acquisitions journal is an example of a substantive test of transactions for the acquisition and payment cycle. Tests of details of balances verify the ending balance in an individual account (such as inventory, accounts receivable, or depreciation expense) on the financial statements. An example of a test of details
of balances for the acquisition and payment cycle is to physically examine a sample of the client's fixed assets.
9) The auditor Ferguson’s Inc. identified two internal controls in the sales and collection receipts cycle for testing. In the first control, the computer verifies that a planned sale on account will not exceed the customer’s credit limit entered in the accounts receivable master file. In the second control, the accounts receivable clerk matches bills of ladding, sales invoices, and customer orders before recording in the sales journal. Describe how the presence of general controls over software programs and master file changes affects the extent of audit testing of each of these two internal controls.
: 1. Control #1 -- Computer verification of the customer’s credit limit. The presence of strong general controls over software programs and master file changes can significantly reduce the auditor’s testing of automated controls such as control #1. Once it is determined that control #1 is functioning properly, the auditor can focus subsequent tests on assessing whether any changes have occurred that would limit the effectiveness of the control. Such tests might include determining whether any changes have occurred to the program and whether these changes were properly authorized and tested prior to implementation. These are all tests of general controls over software programs and master file changes.
2. Control #2 – The accounts receivable clerk matches bills of lading, sales invoices, and customer orders before recording in the sales journal. This control is not an automated control, but is rather a manual control performed by an employee. General controls over software programs and master file changes would have little effect on the auditor’s testing of control #2. If the auditor identifies control #2 as a key control in the sales and collection cycle, he or she would most likely examine a sample of the underlying documents for the accounts receivable clerk’s initials and reperform the comparisons.
10) Assume that the client’s internal controls over the recording and classifying of fixed asset additions are considered deficient because the individual responsible for recording new aquisitions has inadequate technical training and limited experience in accounting. How will this situation affect the evidence you should accumulate in auditing fixed assets as compared with another audit in which the controls are excellent? Be as specific as possible.
: The audit of fixed asset additions normally involves the examination of invoices in support of the additions and possibly the physical examination of the additions. These procedures are normally performed on a test basis with a concentration on the more significant additions. If the individual responsible for recording new acquisitions is known to have inadequate training and limited experience in accounting, the sample size for the audit procedures should be expanded to include a larger sample of the additions for the year. In addition, inquiry as to what additions were made during the year may be made by the auditor of plant managers, the controller, or other operating personnel. The auditor should then search the financial records to determine that these additions were recorded as fixed assets.
Care should also be taken when the repairs and maintenance expense account is analyzed since lack of training may cause some depreciable assets to be expensed at the time of acquisition.
11) For each of the eight types of evidence discussed in chapter 7, identify whether it is applicable for risk assessment procedures,
tests of controls, substantive tests of transactions, analytical procedures, adn tests of details of balances.
: The following shows which types of evidence are applicable for the five types of tests.
TYPE OF EVIDENCE TYPES OF TESTS
Physical examination Tests of details of balances
Confirmation
Tests of details of balances
Documentation
All except analytical procedures
Observation
Procedures to obtain an understanding of internal control and tests of controls
Inquiries of the client
All five types
Reperformance
Tests of controls, substantive tests of transactions, and tests of details of balances
Analytical procedures
Analytical procedures
12) Rank the following types of tests from moct costly to least costly: analytical procedures, tests of details of balances, risk assessment procedures, tests of controls, and substantive tests of transactions.
: Going from most to least costly, the types of tests are:
Tests of details of balances
Substantive tests of transactions
Tests of controls
Procedures to obtain an understanding of internal controls
Analytical procedures
13) In figure 13-3, explain the difference among C3, C2, and C1. Explain the circumstances under which it will be a good decision to obtain audit assurance from substantive tests at point C1. Do the same for points C2, and C3.
: C represents the auditor's assessment of the effectiveness of internal control. C3represents the idea that the auditor chooses not to perform any tests of controls. Since no tests of controls are performed, no assurance can be obtained from controls and all assurance must come from substantive testing. This would not represent the audit of a public company’s financial statements.Tests of controls at the C1 level would provide minimum control risk. This would
require more testing of the controls than would be required at either C2 or C3. Testing controls at the C1 level allows the auditor to obtain assurance from the controls, thereby allowing for a reduction in the amount of substantive testing which must be performed to meet the level of acceptable audit assurance. C1 reflects the level of testing of controls necessary for the audit of internal controls over financial reporting required by PCAOB Standard 2.
It would be a good decision to obtain assurance from tests of controls at point C1 if the cost of substantive testing is considerably greater than tests of controls. However, if the cost of testing controls is high, it may be a good decision to obtain assurance at point C3.
At point C2, the auditor performs some tests of controls and is able to reduce control risk below maximum. Point C2 would be appropriate if it is cost beneficial for the auditor to obtain assurance at a level between the two extremes mentioned above (C1 and C3).
14) Table 13-3 illustrates variations in the emphasis on different types of audit tests. What are the benefits to the auditor of identifying the best mix of tests?
: By identifying the best mix of tests the auditor can accumulate sufficient competent evidence at minimum cost. The auditor can thereby meet the standards of the profession and still be cost effective and competitive.
15) State the four-step approach to designing tests of controls and substantive tests of transactions.
: The four-step approach to designing tests of controls and substantive tests of transactions is as follows:
1. Apply the transaction-related audit objectives to the class of transactions being tested.
2. Identify specific control policies and procedures that should reduce control risk for each transaction-related audit objective.
3. Develop appropriate tests of controls for each key control.
4. Design appropriate substantive tests of transactions considering deficiencies in internal control and expected results from 3 above.
16) Expalin the relationship between the methodology for designing tests of controls and substantive tests of transactions in figure 13-4 to the methodology for designing tests of details of balances in figure 13-6.
: The approach to designing tests of controls and substantive tests of transactions (Figure 13-
4) emphasizes satisfying the transaction-related audit objectives developed in Chapters 6 and
10. Recall that these objectives focus on the proper functioning of the accounting system.
The methodology of designing tests of details of balances (Figure 13-6) emphasizes satisfying the balance-related audit objectives developed in Chapter 6. The primary focus of these objectives is on the fair presentation of account balances in the financial statements.
17) Why is it desirable to design tests of details of balances before performing tests of controls and substantive tests of transactions? State the assumptions that the auditor must make in doing that. What does the auditor do if the assumptions are wrong?
: It is desirable to design tests of details of balances before performing tests of controls and substantive tests of transactions to enable the auditor to determine if the overall planned evidence is the most efficient and effective in the circumstances. In order to do this, the auditor must make assumptions about the results of the tests of controls and substantive tests of transactions. Ordinarily the auditor will assume no significant misstatements or control problems
in tests of controls and substantive tests of transactions unless there is reason to believe otherwise. If the auditor determines that the tests of controls and substantive tests of transactions results are different from those expected, the amount of testing of details of balances must be altered.
18) Explain the relationship of tolerable misstatement, inherent risk, and control risk to planned tests of details of balances.
: If tolerable misstatement is low, and inherent risk and control risk are high, planned tests of details of balances which the auditor must perform will be high. An increase in tolerable misstatement or a reduction of either inherent risk or control risk will lead to a reduction in the planned tests of details of balances.
19) List the nine balance-related audit objectives in the verification of the ending balance in inventory and provide one useful audit procedure for each of the objectives.
: The nine balance-related audit objectives and related procedures are as follows:
GENERAL BALANCE- RELATED AUDIT OBJECTIVE
SPECIFIC OBJECTIVE
AUDIT PROCEDURE
Detail tie-in Inventory on the inventory summary agrees with the physical count, the extensions are correct, and the total is correctly added and agrees with the general ledger. Check extensions of price times quantity on a sample basis, foot the detailed inventory summary, and trace the balance to the general ledger and financial statements.
Existence Inventory as stated in financial statements actually exists. Trace inventory from final inventory summary to actual inventory and physically count selected items.
Completeness Existing inventory items have been counted and included in the financial statements. Select items from the physical inventory and trace to the client's final summary to make sure that all items are included.
Accuracy Inventory items included in the financial statements are stated at the correct amounts. Perform price tests of inventory by examining supporting vendors' invoices for selected inventory items and reverify price times quantity.
Classification Inventory as included in the financial statements is properly classified. Compare the classification of inventory into raw materials, work in process, and finished goods by comparing the description on physical inventory count tags with the client's final inventory listing.
Cutoff Inventory cutoff is properly recorded at the balance sheet date. Trace selected receiving reports several days before and after the balance sheet date to determine whether inventory purchases are recorded in the proper period and related physical inventory counts are included or excluded from inventory.
Realizable value Inventory on the financial statements excludes unusable items. Inquire of factory employees and management regarding obsolescence of inventory, and examine storeroom for evidence of damaged or obsolete inventory.
GENERAL BALANCE- RELATED AUDIT OBJECTIVE
SPECIFIC OBJECTIVE
AUDIT PROCEDURE
Rights and Inventory items in the Review contracts with
obligations financial statements are suppliers and customers for
owned by the client. the possibility of the inclusion
of consigned or other non-
owned inventory.
Presentation and Inventory and related Examine financial statements
disclosure accounts in the inventory and for proper presentation and
warehousing cycle are disclosure including proper
properly presented and description of pledged
disclosed. inventory and inclusion of
significant sales and purchase
commitments.
20) Why do auditors often consider it desirable to perform audit tests throughout the year rather than wait until year-end? List several examples of evidence that can be accumulated before year-end.
: Auditors frequently consider it desirable to perform audit tests throughout the year rather than waiting until year-end because of the CPA firm's difficulty of scheduling personnel. Due to the uneven distribution of the year-end dates of their clients, there is a shortage of personnel during certain periods of the year and excess available time at other periods. The procedures that are performed at a date prior to year-end are often dependent upon adequate internal controls and when the client will have the information available. Additionally, public company auditors must begin their testing of controls earlier in the year to ensure they are able to test a sufficient sample of controls for operating effectiveness. Some controls may only be performed monthly or quarterly. Thus, the public company auditor must begin testing early in the year so that there is a sufficient number of months or quarters to test.
Procedures that may be performed prior to the end of the year are:
1. Update fixed asset schedules.
2. Examine new loan agreements and other legal records.
3. Vouch certain transactions.
4. Analyze changes in the client's accounting systems.
5. Review minutes of board of directors' meetings.
6. If the client has strong internal control, the following procedures may be performed with minor review and updating at year-end:
(a) Observation of physical inventories;
(b) Confirmation of accounts receivable balances;
(c) Confirmation and reconciliation of accounts payable balances.
Completing The Audit
1) Distinguish between a contingent liability and an actual liability and give three examples of each.
: A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Some examples would be:
Pending litigation
Income tax disputes
Product warranties
Notes receivable discounted
Guarantees of obligations of others
Unused balances of outstanding letters of credit
An actual liability is a real future obligation to an outside party for a known amount from activities that have already taken place. Some examples would be:
Notes payable
Accounts payable
Accrued interest payable
Income taxes payable
Payroll withholding liabilities
Accrued salaries and wages
2) In the audit of the James Mobley Company, you are concerned about the possibility of contingent liabilities resulting from income tax disputes. Discuss the procedures you could use for an extensive investigation in this area.
: If you are concerned about the possibility of contingent liabilities for income tax disputes, there are various procedures you could use for an intensive investigation in that area. One good approach would be an analysis of income tax expense. Unusual or nonrecurring amounts should be investigated further to determine if they represent situations of potential tax liability. Another helpful procedure for uncovering potential tax liabilities is to review the general correspondence file for communication with attorneys or internal revenue agents. This might give an indication that the potential for a liability exists even though no actual litigation has begun. Finally, an examination of internal revenue agent reports from prior years may provide the most obvious indication of disputed tax matters.
3) Explain why an auditor is interested in a client’s future commitments to purchase raw materials at affixed price.
: The auditor would be interested in a client's future commitments to purchase raw materials at a fixed price so that this information could be disclosed in the financial statements. The commitment may be of interest to an investor as it is compared to the future price movements of the material. A future commitment to purchase raw materials at a fixed price may result in the client paying more or less than the market price at a future time.
4) Explain why the analysis of legal expense is an essential part of every audit.
: The analysis of legal expense is an essential part of every audit engagement because it may give an indication of contingent liabilities which may become actual liabilities in the future and require disclosure in the current financial statements. Since any single contingency could be material, it is important to verify all legal transactions, even if the amounts are small. After the analysis of legal expense is completed, the attorneys to whom payment was made should be considered for letters of confirmation for contingencies (attorney letters).
5) During the audit of the Merrill Manufacturing Company, Ralph Pyson, CPA, has become aware of four lawsuits against the client though discussions with the client, reading corporate minutes, and reviewing correspondence files. How should Pyson determine the materiality of the lawsuits and the proper disclosure in the financial statements?
: Pyson should determine the materiality of the lawsuits by requesting from Merrill's attorneys an assessment of the legal situations and the probable liabilities involved. In addition, Pyson may have his own attorney assess the situations. Proper disclosure in the financial statements will depend on the attorneys' evaluations of the probable liabilities involved. If the evaluations indicate highly probable, material amounts, disclosure will be necessary in the form of a footnote, assuming the amount of the probable material loss cannot be reasonably estimated. If the client refuses to make adequate disclosure of the contingencies, a qualified or adverse opinion may be necessary.
6) Distinguish between an asserted and unasserted claim. Explain why a client’s attorney may not reveal an unasserted claim.
: An asserted claim is an existing legal action that has been taken against the client, whereas an unasserted claim represents a potential legal action. The client's attorney may not reveal an unasserted claim for fear that the disclosure of this information may precipitate a lawsuit that would be damaging to the client, and that would otherwise not be filed.
7) Describe the action that an auditor should take if an attorney refuses to provide information that is within the attorney’s jurisdiction and may directly affect the fair presentation of the financial statements.
: If an attorney refuses to provide the auditor with information about material existing lawsuits or likely material unasserted claims, the audit opinion would have to be modified to reflect the lack of available evidence. This is required by SAS 12 (AU 337), and has the effect of requiring management to give its attorneys permission to provide contingent liability information to auditors and to encourage attorneys to cooperate with auditors in obtaining information about contingencies.
8) Distinguish between the two general types of subsequent events and explain how they differ. Give two examples of each type.
: The first type of subsequent event is one that has a direct effect on the financial statements and requires adjustment. Examples of this type of subsequent event are as follows:
Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to the deteriorating financial condition
Settlement of a litigation for an amount different from the amount recorded on the books
Disposal of equipment not being used in operations at a price below the current book value
Sale of investments at a price below recorded cost
Sale of raw material as scrap in the period subsequent to the balance sheet date
The second type of subsequent event is one that has no direct effect on the financial statements but for which disclosure is advisable. Examples include the following:
Decline in the market value of securities held for temporary investment or resale
Issuance of bonds or equity securities
Decline in the market value of inventory as a consequence of government action barring further sale of a product
Uninsured loss of inventories as a result of fire
9) In obtaining letters from attorneys, Bill Malano’s aim is to receive the letters as early as possible after the balance sheet date. This provides him with a signed letter from every attorney in time to properly investigate any exceptions. It also eliminates the problem of a lot unresolved loose ends near the end of the audit. Evaluate Malano’s approach.
: Malano's approach does not take into consideration the need to obtain letters from attorneys as near the end of field work as possible. If the letters are received near the balance sheet date, the period from the balance sheet to the end of the auditor's field work will not be included in the attorneys' letters. His procedure would not obtain the most current information regarding contingent liabilities, and would not provide adequate information for disclosure of pertinent subsequent events.
10) What major considerations should the auditor take into account in determining how extensive the review of subsequent events should be?
: The major considerations the auditor should take into account in determining how extensive the subsequent events review should be are:
The company's financial strength and stability of earnings
The effectiveness of the company's internal controls
The number and significance of the adjustments made by the auditor
The length of time between the balance sheet date and the completion of the audit
Changes in key personnel
Auditors of public companies should be aware that PCAOB Standard 2 requires them to also inquire about changes in internal control over financial reporting occurring subsequent to the end of the fiscal period that might significantly affect internal control over financial reporting.
11) Identify five audit procedures normally done as a part of the review for subsequent events
: Audit procedures normally performed as a part of the review for subsequent events are:
Cutoff and valuation tests of various balances and related transactions; e.g., sales cutoff tests
Inquire of management
Correspond with attorneys
Review internal statements prepared subsequent to the balance sheet date
Review records prepared subsequent to the balance sheet date
Examine minutes of meetings of board of directors and stockholders subsequent to the balance sheet date
Obtain a letter of representation
12) Distinguish between subsequent events occurring between the balance sheet date and the date of the auditor’s report, and subsequent discovery of facts existing at the date of the auditor’s report. Give two examples of each and explain the appropriate action by the auditor in each instance.
: Subsequent events occurring between the balance sheet date and the date of the auditor's report are those transactions and events which might affect the financial statements being audited (either adjustment, disclosure, or both). Examples of these types of events would be:
Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due because of a deteriorating financial condition
Settlement of a litigation for an amount different from the amount recorded on the books
Disposal of equipment not being used in operations at a price below the current book value
Sale of investments at a price below recorded cost
Sale of raw material as scrap in the period subsequent to the balance sheet date
Decline in the market value of securities held for temporary investment or resale
Issuance of bonds or equity securities
Decline in the market value of inventory as a consequence of government action barring further sale of a product
Uninsured loss of inventories as a result of fire
If these events and transactions have a material effect on the financial statements, they may require adjustment of the current period financial statements or disclosure. Auditors of public companies should also be alert for subsequent changes in internal control over financial reporting.
The subsequent discovery of facts existing at the date of the auditor's report occurs when the auditor becomes aware that some information included in the financial statements was materially misleading after the audited financial statements have been issued. Some examples of such facts would be:
Subsequent discovery of the inclusion of fraudulent sales
Subsequent discovery of the failure to write-off obsolete inventory
Omission of an essential footnote
In such cases when the auditor discovers the statements to be misleading, he or she should request the client to issue a revised set of financial statements as soon as possible containing a new audit report and an explanation of the reasons for the revisions to the financial statements.
13) Miles Lawson, CPA, believes that the final summarization is the easiest part of the audit if careful planning is follow throughout the audit. He makes sure that each segment of the audit is completed, he is finished with the audit. He believes this may cause each part of the audit to take a little longer, but he makes up for it by not having to do the final summarization. Evaluate Lawson’s approach.
: The weakness in Lawson's approach is the danger of discovering an inadequacy in one audit area which could affect other areas of the audit. For example, if misstatements were discovered as part of the tests of controls for sales, the initial plans for the tests of details of balances for accounts receivable may have been insufficient and should have been revised. Similarly, the audit of fixed assets is related to the contracts and notes payable whenever fixed assets are used as collateral.
Another difficulty with Lawson's approach is that there is no combining of the misstatements in different audit areas to determine if the combined misstatements are material. If the combined misstatements are considered material, it may be necessary to expand the testing in certain areas or require adjusting entries to some balances.
14) Compare and contrast the accumulation of audit evidence and the evaluation of the adequacy of the disclosures in the financial statements. Give two examples in which adequate disclosure could depend heavily on the accumulation of evidence and two others in which audit evidence does not normally significantly affect the adequacy of the disclosure.
: The accumulation of audit evidence is crucial to the auditor in determining whether the financial statements are stated in accordance with generally accepted accounting principles, applied on a basis consistent with the preceding year. The evaluation of the adequacy of the disclosures in financial statements is made to determine that the account balances on the trial balance are properly aggregated and disclosed on the financial statements.
Examples where adequate disclosure could depend heavily upon the accumulation of evidence are:
The disclosure of declines in inventory values below cost
The segregation of current from noncurrent receivables
The segregation of trade accounts receivable from amounts due from affiliates
The disclosure of contingent liabilities that the auditor has not been informed of by the client
Examples where audit evidence does not normally significantly affect the adequacy of the disclosure are:
Deciding whether a disposal of equipment should be recorded as an extraordinary item
The disclosure of an acquisition as a pooling of interests or a purchase
The disclosure of contingencies that the auditor was informed of by the client
15) Distinguish between a client letter of representation and a management letter and state the primary purpose of each. List some items that might be included in each letter.
: A letter of representation is a written communication from the client to the auditor which formalizes statements that the client has made about matters pertinent to the audit. SAS 85 (AU 333) suggests four categories of items that should be included in the letter. Below are those four items with examples in each category follow (refer students to SAS 85―AU 333―for a comprehensive list):
1. Financial statements
Management's acknowledgment of its responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles
Management’s belief that the financial statements are fairly presented in conformity with generally accepted accounting principles
2. Completeness of information
Availability of all financial records and related data
Completeness and availability of all minutes or meetings of stockholders, directors, and committees of directors
Absence of unrecorded transactions
3. Recognition, measurement, and disclosure
Management’s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements
Information concerning fraud involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements
Information concerning related party transactions and amounts receivable from or payable to related parties
Unasserted claims or assessments that the entity’s lawyer has advised are probable of assertion and must be disclosed in accordance with Financial Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies
Satisfactory title to assets, liens or encumbrances on assets, and assets pledged as collateral
Compliance with aspects of contractual agreements that may affect the financial statements
4. Subsequent events
Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date
A merger or acquisition after the balance sheet date
For audits of public companies, PCAOB Standard 2 requires the auditor to obtain specific representations from management about internal control over financial reporting. Some of those representations are noted below:
5. Internal controls
Management’s acknowledgement of its responsibility for establishing and maintaining effective internal controls over financial reporting.
Management’s conclusion about the effectiveness of internal control over financial reporting as of the end of the fiscal period.
Disclosure to the auditor of all deficiencies in the design or operation of internal control over financial reporting identified as part of management’s assessment, including separate disclosure of significant deficiencies and material weaknesses.
Management’s knowledge of any material fraud or other fraud involving senior management or other employees who have a significant role in the company’s internal control over financial reporting.
Auditors of public companies may obtain a combined representation letter for both the audit of the financial statements and the audit of internal control over financial reporting.
A management letter is a letter directed to the client to inform management of certain recommendations about the business which the CPA believes would be beneficial to the client.
Items that might be included in a management letter are:
Recommendation to switch inventory valuation methods
Recommendation to install a formal security system
Recommendation to prepare more timely bank reconciliations
Recommendation to segregate duties
Recommendation to have certain types of transactions authorized by specific individuals
16) Explain what is meant by information accompanying basic financial statements. Provide two examples of such information. What levels of assurance may the CPA offer for this information?
: Information accompanying basic financial statements is any and all information prepared for management or outside users included with the basic financial statements. Examples include detailed comparative statements supporting control totals in the basic statements, supplementary information required by the SEC, statistical data such as ratios and trends, and specific comments on the changes that have taken place in the financial statements.
The auditor can provide one of two levels of assurance for information accompanying basic financial statements. The auditor may issue a positive opinion indicating a high level of assurance, or a disclaimer indicating no assurance.
17) What is meant by reading other financial information in annual reports? Give an example of the type of information the auditor is examining.
: SAS 8 (AU 550) requires the auditor to read information in annual reports containing audited financial statements for consistency with the financial statements and the auditor's report. Types of information the auditor examines include statements about financial condition in the president's letter and displays and summaries of statistical financial information.
18) Distinguish between regular audit documentation review and independent review and state the purpose of each. Give two examples of potential findings in each of these two types of review.
: A regular audit documentation review is the one that is done by someone who is knowledgeable about the client and the unique circumstances in the audit. The purposes of this review are to:
Evaluate the performance of inexperienced personnel
To make sure that the audit meets the CPA firm's standard of performance
To counteract the bias that frequently enters into the auditor's judgment.
Examples of important potential findings in a regular audit documentation review are:
Incorrect computations
Inadequate scope
Lack of proper documentation for audit decisions
An independent review is one done by a completely independent person who has no experience on the engagement. The purpose is to have a competent professional from within the firm who has not been biased by the ongoing relationship between the regular auditors and the client perform an independent review. Examples of important potential findings in an independent review are:
A number of small adjustments waived that should have been accumulated into an adjusting journal entry due to materiality
Too narrow and too biased of a scope in an audit area
Inadequate disclosure of contingencies
19) Describe matters that the auditor must communicate to audit committees of public companies.
24.19 : In addition to the SAS 61 required audit committee communications, the Sarbanes-Oxley Act expands these communications requirements by also requiring public company auditors to timely report the following items to the audit committee:
All critical accounting policies and practices to be used.
All alternative treatments of financial information within generally accepted accounting principles that have been discussed with management, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the auditor.
Other material written communications between the auditor and management, such as any management letter or schedule of unadjusted differences.
As the audit of the public company is completed, the auditor should determine that the audit committee is informed about the initial selection of and changes in significant accounting policies or their application during the current audit period. When changes have occurred, the auditor should inform the committee of the reasons for the change. The auditor should also communicate information about methods used to account for significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas.
The End
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