Auditing and Assurance Services 14th Edition – Chapters End Problems Solved – Chapter 1-26

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Auditing and Assurance Services 14th edition

Chapter 1

1-1 (Objective 1-5) Explain the relationships among audit services, attestation services, and assurance services, and give examples of each.

1-2 (Objective 1-3) Discuss the major factors in today’s society that have made the need for independent audits much greater than it was 50 years ago.

1-3 (Objective 1-3) Distinguish among the following three risks: risk-free interest rate, business risk, and information risk. Which one or ones does the auditor reduce by per- forming an audit?

1-4 (Objective 1-4) Identify the major causes of information risk and identify the three main ways information risk can be reduced. What are the advantages and disadvantages of

each?

1-5 (Objective 1-1) Explain what is meant by determining the degree of correspondence between information and established criteria. What are the information and established criteria for the audit of Jones Company’s tax return by an internal revenue agent? What are they for the audit of Jones Company’s financial statements by a CPA firm?

1-6 (Objectives 1-1, 1-7) Describe the nature of the evidence the internal revenue agent will use in the audit of Jones Company’s tax return.

1-7 (Objective 1-2) In the conduct of audits of financial statements, it would be a serious breach of responsibility if the auditor did not thoroughly understand accounting. However, many competent accountants do not have an understanding of the auditing process. What causes this difference?

1-8 (Objective 1-6) What are the differences and similarities in audits of financial state- ments, compliance audits, and operational audits?

1-9 (Objectives 1-6, 1-7) List five examples of specific operational audits that can be conducted by an internal auditor in a manufacturing company.

1-10 (Objectives 1-5, 1-6) What knowledge does the auditor need about the client’s business in an audit of historical financial statements? Explain how this knowledge may be useful in performing other assurance or consulting services for the client.

1-11 (Objective 1-7) What are the major differences in the scope of the audit respon- sibilities for CPAs, GAO auditors, IRS agents, and internal auditors?

1-12 (Objective 1-8) Identify the four parts of the Uniform CPA Examination.

1-13 (Objective 1-5) Explain why CPAs need to be knowledgeable about information

technology, including e-commerce technologies.

3. A report stating whether the company has complied with restrictive covenants related to officer compensation and payment of dividends contained in a bank loan

agreement.

4. An electronic seal indicating that an electronic seller observes certain practices.

5. A report indicating whether a governmental entity has complied with certain

government regulations.

6. A report on the examination of a financial forecast.

7. A review report that provides limited assurance about whether financial statements

are fairly stated in accordance with U.S. GAAP.

8. A report on management’s assertion on the company’s level of carbon emissions.

9. A report about management’s assertion on the effectiveness of controls over the

availability, reliability, integrity, and maintainability of its accounting information

system.

10. An evaluation of the effectiveness of key measures used to assess an entity’s success

in achieving specific targets linked to an entity’s strategic plan and vision.

a. Explain or use a diagram to indicate the relationships among audit services, attesta- Required tion services, and assurance services.

b. For each of the services listed above, indicate the type of service from the list that follows.

(1) An audit of historical financial statements.

(2) An attestation service other than an audit service.

(3) An assurance service that is not an attestation service.

1-17 (Objective 1-3) Busch Corporation has an existing loan in the amount of $4.5 million with an annual interest rate of 5.5%. The company provides an internal company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace Busch Corporation’s existing loan agreement with a new one. United National Bank has offered to loan Busch $4.5 million at a rate of 4.5% but requires Busch to provide financial statements that have been reviewed by a CPA firm. First City Bank has

Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES

21

22

Required

offered to loan Busch $4.5 million at a rate of 3.5% but requires Busch to provide financial statements that have been audited by a CPA firm. Busch Corporation’s controller approached a CPA firm and was given an estimated cost of $20,000 to perform a review and $45,000 to perform an audit.

a. Explain why the interest rate for the loan that requires a review report is lower than that for the loan that did not require a review. Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans.

b. Calculate Busch Corporation’s annual costs under each loan agreement, including interest and costs for the CPA firm’s services. Indicate whether Busch should keep its existing loan, accept the offer from United National Bank, or accept the offer from First City Bank.

c. Assume that United National Bank has offered the loan at a rate of 4.0% with a review, and the cost of the audit has increased to $55,000 due to new auditing standards requirements. Indicate whether Busch should keep its existing loan, accept the offer from United National Bank, or accept the offer from First City Bank.

d. Discuss why Busch may desire to have an audit, ignoring the potential reduction in interest costs.

e. Explain how a strategic understanding of the client’s business may increase the value of the audit service.

1-18 (Objectives 1-3, 1-4, 1-5) Consumers Union is a nonprofit organization that provides information and counsel on consumer goods and services. A major part of its function is the testing of different brands of consumer products that are purchased on the open market and then the reporting of the results of the tests in Consumer Reports, a monthly publication. Examples of the types of products it tests are middle-sized automobiles, residential dehumidifiers, flat-screen TVs, and boys’ jeans.

a. InAwphat wgaoys arePthDeFserviEcesnphrovaidnedcbey Cronsumers Union similar to assurance services provided by CPA firms?

b. Compare the concept of information risk introduced in this chapter with the infor- mation risk problem faced by a buyer of an automobile.

c. Compare the four causes of information risk faced by users of financial statements as discussed in this chapter with those faced by a buyer of an automobile.

d. Compare the three ways users of financial statements can reduce information risk with those available to a buyer of an automobile.

1-19 (Objective 1-1) James Burrow is the loan officer for the National Bank of Dallas. National has a loan of $325,000 outstanding to Regional Delivery Service, a company specializing in delivering products of all types on behalf of smaller companies. National’s collateral on the loan consists of 25 small delivery trucks with an average original cost of $24,000.

Burrow is concerned about the collectibility of the outstanding loan and whether the trucks still exist. He therefore engages Samantha Altman, CPA, to count the trucks, using registration information held by Burrow. She was engaged because she spends most of her time auditing used automobile and truck dealerships and has extensive specialized knowledge about used trucks. Burrow requests that Altman issue a report stating the following:

1. Which of the 25 trucks is parked in Regional’s parking lot on the night of June 30, 2011.

2. Whether all of the trucks are owned by Regional Delivery Service.

3. The condition of each truck, using the guidelines of poor, good, and excellent.

4. The fair market value of each truck, using the current “blue book” for trucks, which

states the approximate wholesale prices of all used truck models, and also using the poor, good, and excellent condition guidelines.

Required

Part 1 / THE AUDITING PROFESSION

a. For each of the following parts of the definition of auditing, state which part of the preceding narrative fits the definition:

(1) Information

(2) Established criteria

(3) Accumulating and evaluating evidence (4) Competent,independentperson

(5) Reporting results

b. Identify the greatest difficulties Virms is likely to have doing this audit.

1-20 (Objective 1-7) Five college seniors with majors in accounting are discussing alter- native career plans. The first senior plans to become an internal revenue agent because his primary interest is income taxes. He believes the background in tax auditing will provide him with better exposure to income taxes than will any other available career choice. The second senior has decided to go to work for a CPA firm for at least 5 years, possibly as a permanent career. She believes the variety of experience in auditing and related fields offers a better alternative than any other available choice. The third senior has decided on a career in internal auditing with a large industrial company because of the many different aspects of the organization with which internal auditors become involved. The fourth senior plans to become an auditor for the GAO because she believes that this career will provide excellent experience in computer risk assessment techniques. The fifth senior plans to pursue some aspect of auditing as a career but has not decided on the type of organization to enter. He is especially interested in an opportunity to continue to grow professionally, but meaningful and interesting employment is also a consideration.

a. What are the major advantages and disadvantages of each of the four types of auditing careers?

Required

b. What other types of auditing careers are available to those who are qualified?

1-21 (Objectives 1-6, 1-7) In the normal course of performing their responsibilities,

auditors often conduct audits or revieAwspofathge followPinDg: F Enhancer

1. Federal income tax returns of an officer of the corporation to determine whether he or she has included all taxable income in his or her return.

2. Disbursements of a branch of the federal government for a special research project to determine whether it would have been possible to accomplish the same research results at a lower cost to the taxpayers.

3. Computer operations of a corporation to evaluate whether the computer center is being operated as efficiently as possible.

4. Annual statements for the use of management.

5. Operations of the IRS to determine whether the internal revenue agents are using

their time efficiently in conducting audits.

6. Statements for bankers and other creditors when the client is too small to have an

audit staff.

7. Financial statements of a branch of the federal government to make sure that the

statements present fairly the actual disbursements made during a period of time.

8. Federal income tax returns of a corporation to determine whether the tax laws have

been followed.

9. Financial statements for use by stockholders when there is an internal audit staff.

10. A bond indenture agreement to make sure a company is following all requirements of the contract.

11. The computer operations of a large corporation to evaluate whether the internal controls are likely to prevent misstatements in accounting and operating data.

12. Disbursements of a branch of the federal government for a special research project to determine whether the expenditures were consistent with the legislative bill that authorized the project.

a. For these 12 examples, state the most likely type of auditor (CPA, GAO, IRS, or internal) to perform each.

Required

Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES

Required

23

Required

b. In each example, state the type of audit (financial statement audit, operational audit, or compliance audit).

1-22 (Objectives 1-3, 1-5) Dave Czarnecki is the managing partner of Czarnecki and Hogan, a medium-sized local CPA firm located outside of Chicago. Over lunch, he is surprised when his friend James Foley asks him, “Doesn’t it bother you that your clients don’t look forward to seeing their auditors each year? Dave responded, “Well, auditing is only one of several services we provide. Most of our work for clients does not involve financial statement audits, and our audit clients seem to like interacting with us.”

a. Identify ways in which a financial statement audit adds value for clients.

b. List other services other than audits that Czarnecki and Hogan likely provides.

c. Assume Czarnecki and Hogan has hired you as a consultant to identify ways in which they can expand their practice. Identify at least one additional service that you believe the firm should provide and explain why you believe this represents a growth opportunity for CPA firms.

INTERNET PROBLEM 1-1: CPA REQUIREMENTS

Required

Individuals are licensed as CPAs by individual states. Information on the requirements for each state can be found on the National Association of State Boards of Accountancy (NASBA) web site (www.nasba.org). The Uniform CPA Examination is administered by the American Institute of Certified Public Accountants (AICPA), and information on CPA examination requirements can be found on the AICPA web site (www.aicpa.org).

a. Identify the education requirements to be eligible to sit for the CPA exam in your state. Include any specific educational content requirements.

Part 1 / THE AUDITING PROFESSION

b. List any frequently asked questions (FAQ) for your state, if there are any.

c. What are the Elijah Watts Sells awards?

d. What was the passing rate for each exam section in the most recent quarter?

Chapter 2

2-1 (Objective 2-1) State the four major types of services CPAs perform, and explain each. 2-2 (Objectives 2-1, 2-7) What major characteristics of the organization and conduct of

CPA firms permit them to fulfill their social function competently and independently? 2-3 (Objective 2-2) What is the role of the Public Company Accounting Oversight Board?

2-4 (Objective 2-3) Describe the role of the SEC in society and discuss its relationship with and influence on the practice of auditing.

2-5 (Objective 2-4) What roles are played by the American Institute of Certified Public Accountants for its members?

Part 1 / THE AUDITING PROFESSION

40

2-6 (Objective 2-4) What are the purposes of the AICPA Statements on Standards for Attestation Engagements?

2-7 (Objectives 2-2, 2-4, 2-5) Who is responsible for establishing auditing standards for audits of U.S. public companies? Who is responsible for establishing auditing standards for U.S. private companies? Explain.

2-8 (Objective 2-6) Distinguish between generally accepted auditing standards and gen- erally accepted accounting principles, and give two examples of each.

2-9 (Objective 2-6) The first standard of field work requires the performance of the audit by a person or persons having adequate technical training and proficiency as an auditor. What are the various ways in which auditors can fulfill the requirement of the standard?

2-10 (Objective 2-6) Generally accepted auditing standards have been criticized by different sources for failing to provide useful guidelines for conducting an audit. The critics believe the standards should be more specific to enable practitioners to improve the quality of their performance. As the standards are now stated, some critics believe that they provide little more than an excuse to conduct inadequate audits. Evaluate this criticism of the 10 generally accepted auditing standards.

2-11 (Objective 2-5) Describe the role of International Standards on Auditing. What is the relationship between International Standards on Auditing and U.S. Generally Accepted Auditing Standards?

2-12 (Objective 2-7) What is meant by the term quality control as it relates to a CPA firm?

2-13 (Objective 2-7) The following is an example of a CPA firm’s quality control procedure requirement: “Any person being considered for employment by the firm must have completed a basic auditing course and have been interviewed and approved by an audit partner of the firm before he or she can be hired for the audit staff.” Which element of quality control does this procedure affect and what is the purpose of the requirement?

2-14 (Objective 2-7) State what is meant by the term peer review. What are the implications

of peer review for the profession?

2-15 (Objective 2-7) What are the two AICPA resource centers to which CPA firms may belong? What are the primary purposes of the two centers?

DISCUSSION QUESTIONS AND PROBLEMS

2-18 (Objectives 2-2, 2-7) The following comments summarize the beliefs of some practitioners about the Sarbanes–Oxley Act and the PCAOB.

The Sarbanes–Oxley Act is unnecessary regulation of the profession. The costs of requirements such as reporting on the effectiveness of internal control over financial reporting greatly exceed the benefits. These increased costs will discourage companies from issuing publicly traded stock in the United States. The regulation also gives a competitive advantage to national CPA firms because they are best prepared to meet the increased requirements of the Act. Three things already provide sufficient assurance that quality audits are performed without PCAOB oversight. They are competitive pressures to do quality work, legal liability for inadequate performance,

Part 1 / THE AUDITING PROFESSION

42

and a code of professional conduct requiring that CPA firms follow generally accepted auditing standards.

a. State the pros and cons of those comments.

b. Evaluate whether the Sarbanes–Oxley Act and PCAOB regulation are worth their cost.

2-19 (Objective 2-7) For each of the following procedures taken from the quality control manual of a CPA firm, identify the applicable element of quality control from Table 2-4 on page 38.

Required

a.

b. c.

d. e.

f. g. h.

i .

j .

Appropriate accounting and auditing research requires adequate technical reference materials. Each firm professional has online password access through the firm’s Internet Web site to electronic reference materials on accounting, auditing, tax, SEC, and other technical information, including industry data.

Each office of the firm shall be visited at least annually by review persons selected by the director of accounting and auditing. Procedures to be undertaken by the reviewers are illustrated by the office review program.

All potential new clients are reviewed before acceptance. The review includes consultation with predecessor auditors, and background checks. All new clients are approved by the firm management committee, including assessing whether the firm has the technical competence to complete the engagement.

Each audit engagement must include a concurring partner review of critical audit decisions.

Audit engagement team members enter their electronic signatures in the firm’s engagement management software to indicate the completion of specific audit program steps. At the end of the audit engagement, the engagement management software will not allow archiving of the engagement file until all audit program steps have been electronically signed.

At all stages of any engagemenAt, apnaeffgorot is mPadDeFto inEvonlvehparofnesscioenarl staff at appropriate levels in the accounting and auditing decisions. Various approvals of the manager or senior accountant are obtained throughout the audit.

No employee will have any direct or indirect financial interest, association, or rela- tionship (for example, a close relative serving a client in a decision-making capacity) not otherwise disclosed that might be adverse to the firm’s best interest.

Individual partners submit the nominations of those persons whom they wish to be considered for partner. To become a partner, an individual must have exhibited a high degree of technical competence; must possess integrity, motivation, and judgment; and must have a desire to help the firm progress through the efficient dispatch of the job responsibilities to which he or she is assigned.

Through our continuing employee evaluation and counseling program and through the quality control review procedures as established by the firm, educational needs are reviewed and formal staff training programs modified to accommodate changing needs. At the conclusion of practice office reviews, apparent accounting and auditing deficiencies are summarized and reported to the firm’s director of personnel.

The firm’s mission statement indicates its commitment to quality, and this commit- ment is emphasized in all staff training programs.

2-20 (Objectives 2-2, 2-3, 2-6) The Howard Mobile Home Manufacturing Company is audited by Olson and Riley, CPAs. Howard Mobile Home has decided to issue stock to the public and wants Olson and Riley to perform all the audit work necessary to satisfy the requirements for filing with the SEC. Olson and Riley has never had a client go public before.

a. What factors should Olson and Riley consider before accepting the engagement?

b. List additional issues confronting auditors of companies that file with the SEC as compared to dealing with a private company audit client.

Required

Chapter 2 / THE CPA PROFESSION

43

Required

2-21 (Objective 2-6) Ray, the owner of a small company, asked Holmes, a CPA, to conduct an audit of the company’s records. Ray told Holmes that an audit was to be completed in time to submit audited financial statements to a bank as part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor’s report within 3 weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted.

Holmes hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes told the students not to spend time reviewing internal controls but instead to concentrate on proving the mathematical accuracy of the ledger accounts and summarizing the data in the accounting records that support Ray’s financial statements. The students followed Holmes’s instructions and after 2 weeks gave Holmes the financial statements, which did not include footnotes. Holmes reviewed the statements and prepared an unqualified auditor’s report. The report did not refer to generally accepted accounting principles or to the consistent application of such principles.

Briefly describe each of the 10 generally accepted auditing standards and indicate how the action(s) of Holmes resulted in a failure to comply with each standard.

Organize your answer as follows:*

Holmes’ Actions Resulting in Failure Brief Description of GAAS to Comply with GAAS

2-22 (Objective 2-5) For each engagement described below, indicate whether the engage- ment is likely to be conducted under international auditing standards, U.S. generally accepted auditing standards, or PCAOB auditing standards.

a. b. c. d.

e. f . g.

h.

An audit of a U.S. private company with no public equity or debt.

An audit of a German private company with public debt in Germany.

An audit of a U.S. public company.

An audit of a United Kingdom public company that is listed in the United States and whose financial statements will be filed with the SEC.

An audit of a U.S. not-for-profit organization.

An audit of a U.S. private company to be used for a loan from a publicly-traded bank.

An audit of a U.S public company that is a subsidiary of a Japanese company that will be used for reporting by the parent company in Japan.

An audit of a U.S. private company that has publicly-traded debt.

INTERNET PROBLEM 2-1: INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD

Required

International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB). Use the IAASB web site (http://www.ifac.org/IAASB/) to learn more about the IAASB and its standard-setting activities.

a. What is the objective of the IAASB? Who uses International Standards on Auditing? b. Summarize the due process followed by the IAASB in setting standards.

c. How is the IAASB committed to transparency in the standard-setting process?

Chapter 3

Review Question

3-1 (Objective 3-1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording.

3-2 (Objective 3-1) 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 a qualified report?

3-3 (Objective 3-1) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important information included in the scope paragraph.

3-4 (Objective 3-1) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important information included in the opinion paragraph.

3-5 (Objective 3-1) On February 17, 2012, a CPA completed all the evidence gathering procedures on the audit of the financial statements for the Buckheizer Technology Corporation for the year ended December 31, 2011. The audit is satisfactory in all respects except for the existence of a change in accounting principles from FIFO to LIFO inventory

Part 1 / THE AUDITING PROFESSION

66

valuation, which results in an explanatory paragraph on 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?

3-6 (Objective 3-2) What five circumstances are required for a standard unqualified report to be issued?

3-7 (Objective 3-3) Describe the information included in the introductory, scope, and opinion paragraphs in a separate audit report on the effectiveness of internal control over financial reporting. What is the nature of the additional paragraphs in the audit report?

3-8 (Objectives 3-4, 3-7) 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?

3-9 (Objectives 3-4, 3-5) Distinguish between an unqualified report with an 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.

3-10 (Objective 3-4) Describe what is meant by reports involving the use of other auditors. What are the three options available to the principal auditor and when should each be used?

3-11 (Objective 3-4) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should this be reflected in the auditor’s report?

3-12 (Objective 3-4) Distinguish between changes that affect consistency and those that may affect comparability but not consistency. Give an example of each.

3-13 (Objective 3-5) List the three conditions that require a departure from an unqualified opinion and give one specific example of each of those conditions.

3-14 (Objective 3-5) Distinguish between a qualified opinion, an adverse opinion, and a

disclaimer of opinion, and explain the circumstances under which each is appropriate.

3-15 (Objective 3-6) Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of materiality?

3-16 (Objective 3-6) Explain how materiality differs for failure to follow GAAP and for lack of independence.

3-17 (Objective 3-7) 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 will the auditor be most likely to issue a disclaimer of opinion? Explain.

3-18 (Objective 3-5) Distinguish between a report qualified as to opinion only and one with both a scope and opinion qualification.

3-19 (Objectives 3-6, 3-7) Identify the three alternative opinions that may be appropriate when the client’s financial statements are not in accordance with GAAP. Under what circumstance is each appropriate?

3-20 (Objective 3-8) When an auditor discovers more than one condition that requires departure from or modification of the standard unqualified report, what should the auditor’s report include?

3-21 (Objective 3-9) The ISAs allow an auditor to include either of the following phrases in the auditor’s opinion paragraph: (1) “The financial statements present fairly in all material respects . . .” or (2) “The financial statements give a true and fair view of . . .”. Discuss whether the ASB should adopt a similar option for U.S. audit standards.

3-22 (Objective 3-9) Discuss why the adoption of international accounting and auditing standards might be beneficial to investors and auditors.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

3-23 (Objectives 3-1, 3-2, 3-3, 3-4, 3-8) The following questions concern unqualified audit reports. Choose the best response.

a. Which of the following statements about a combined report on the financial state- ments and internal control over financial reporting is correct?

(1) The auditor’s opinion on internal control is for the same period of time as the

opinion on the financial statements.

(2) The report includes additional paragraphs for the definition and limitations of

internal control.

(3) The introductory, scope, and opinion paragraphs are unchanged from a report

for an audit of the financial statements only.

(4) GAAP is the framework used to evaluate internal control.

b. The date of the CPA’s opinion on the financial statements of the client should be the date of the

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

closing of the client’s books.

finalization of the terms of the audit engagement. completion of all important audit procedures. submission of the report to the client.

c. If a

auditor, he or she is required to disclose the

(1) name of the other auditor.

(2) nature of the inquiry into the other auditor’s professional standing and extent of

the review of the other auditor’s work.

(3) portion of the financial statements audited by the other auditor.

(4) reasonsforbeingunwillingtoassumeresponsibilityfortheotherauditor’swork.

principal auditor decides to refer in his or her report to the audit of another

3-24 (Objectives 3-4, 3-8) The following questions concern unqualified audit reports with

an explanatory paragraph or modified wording. Choose the best response.

Part 1 / THE AUDITING PROFESSION

a. An entity changed from the straight-line method to the declining-balance method of depreciation for all newly acquired assets. This change has no material effect on the current year’s financial statements but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a(n)

(1) qualified opinion.

(2) unqualified opinion with explanatory paragraph.

(3) unqualified opinion.

(4) qualified opinion with explanatory paragraph regarding consistency.

b. When the financial statements are fairly stated but the auditor concludes there is sub- stantial doubt whether the client can continue in existence, the auditor should issue a(an)

(1) adverse opinion.

(2) qualified opinion only.

(3) unqualified opinion.

(4) unqualified opinion with explanatory paragraph.

c. The introductory paragraph of an auditor’s report contains the following: “We did not audit the financial statements of EZ Inc., a wholly owned subsidiary, which statements reflect total assets and revenues constituting 27 percent and 29 percent, respectively, of the consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for EZ Inc., is based solely on the report of the other auditors.” These sentences

(1) indicate a division of responsibility.

(2) assume responsibility for the other auditor.

(3) require a departure from an unqualified opinion. (4) are an improper form of reporting.

68

3-25 (Objectives 3-5, 3-7, 3-8) The following questions concern audit reports other than unqualified audit reports with standard wording. Choose the best response.

a. The annual audit of Midwestern Manufacturing revealed that sales were accidentally being recorded as revenue when the goods were ordered, instead of when they were shipped. Assuming the amount in question is material and the client is unwilling to correct the error, the CPA should issue:

(1) an unqualified opinion or adverse opinion.

(2) aqualified“exceptfor”opinionordisclaimerofopinion. (3) aqualified“exceptfor”opinionoradverseopinion.

(4) an unqualified opinion with an explanatory paragraph

b. Under which of the following circumstances would a disclaimer of opinion not be appropriate?

(1) The auditor is unable to determine the amounts associated with an employee

fraud scheme.

(2) Managementdoesnotprovidereasonablejustificationforachangeinaccounting

principles.

(3) The client refuses the auditor permission to confirm certain accounts receivable

or apply alternative procedures to verify their balances.

(4) The chief executive officer is unwilling to sign the management representation

letter.

c . The opinion paragraph of a CPA’s report states: “In our opinion, except for the effects of not capitalizing certain lease obligations, as discussed in the preceding paragraph, the financial statements present fairly,” in all material respects, . . . This paragraph expresses a(an)

(1) Unqualified opinion.

(2) Unqualified opinion with explanatory paragraph. (3) Qualified opinion.

(4) Adverse opinion.

DISCUSSION QUESTIONS AND PROBLEMS

3-26 (Objective 3-1) A careful reading of an unqualified report indicates several important phrases. Explain why each of the following phrases or clauses is used rather than the alternative provided:

a. “The financial statements referred to above present fairly in all material respects the financial position” rather than “The financial statements mentioned above are correctly stated.”

b. “In conformity with accounting principles generally accepted in the United States of America” rather than “are properly stated to represent the true economic conditions.”

c. “In our opinion, the financial statements present fairly” rather than “The financial statements present fairly.”

d. “Brown & Phillips, CPAs (firm name),” rather than “James E. Brown, CPA (individual partner’s name).”

e. “We conducted our audit in accordance with auditing standards generally accepted in the United States of America” rather than “Our audit was performed to detect material misstatements in the financial statements.”

3-27 (Objectives 3-1, 3-2, 3-4, 3-6, 3-7) Patel, CPA, has completed the audit of the financial statements of Bellamy Corporation as of and for the year ended December 31, 2011. Patel also audited and reported on the Bellamy financial statements for the prior year. Patel drafted the following report for 2011.

We have audited the balance sheet and statements of income and retained earnings of Bellamy Corporation as of December 31, 2011. We conducted our audit in accor-

Chapter 3 / AUDIT REPORTS 69

 

Required

dance with generally accepted accounting standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the finan- cial statements are free of misstatement.

We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly the finan- cial position of Bellamy Corporation as of December 31, 2011, and the results of its operations for the year then ended in conformity with generally accepted auditing standards, applied on a basis consistent with those of the preceding year.

Patel, CPA (Signed)

Other Information

• Bellamy is presenting comparative financial statements.

• Bellamy does not wish to present a statement of cash flows for either year.

• During 2011, Bellamy changed its method of accounting for long-term construction

contracts and properly reflected the effect of the change in the current year’s financial statements and restated the prior year’s statements. Patel is satisfied with Bellamy’s justification for making the change. The change is discussed in footnote 12.

• Patel was unable to perform normal accounts receivable confirmation procedures, but alternative procedures were used to satisfy Patel as to the existence of the receivables.

• Bellamy Corporation is the defendant in a litigation, the outcome of which is highly

uncertain. If the case is settled in favor of the plaintiff, Bellamy will be required to pay a substantial amount of cash, which might require the sale of certain fixed assets. The litigation and the possible effects have been properly disclosed in footnote 11.

• Bellamy issued debentures on January 31, 2010, in the amount of $10 million. The funds obtained from the issuance were used to finance the expansion of plant facilities. The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 2015. Bellamy declined to disclose this essential data in the foot- notes to the financial statements.

a. Identify and explain any items included in “Other Information” that need not be part of the auditor’s report.

b. Explain the deficiencies in Patel’s report as drafted.*

3-28 (Objectives 3-4, 3-5, 3-6, 3-7, 3-8) For the following independent situations, assume that you are the audit partner on the engagement:

1. During your audit of Raceway.com, Inc., you conclude that there is a possibility that inventory is materially overstated. The client refuses to allow you to expand the scope of your audit sufficiently to verify whether the balance is actually misstated.

2. You complete the audit of Munich Department Store, and in your opinion, the financial statements are fairly presented. On the last day of the audit, you discover that one of your supervisors assigned to the audit has a material investment in Munich.

3. Auto Delivery Company has a fleet of several delivery trucks. In the past, Auto Delivery had followed the policy of purchasing all equipment. In the current year, they decided to lease the trucks. The method of accounting for the trucks is therefore changed to lease capitalization. This change in policy is fully disclosed in footnotes.

4. You are auditing Deep Clean Services for the first time. Deep Clean has been in business for several years but over the last two years has struggled to stay afloat given the economic conditions. Based on your audit work, you have substantial doubt that Deep Clean will be in business by the end of its next fiscal year.

5. One of your audit clients has a material investment in a privately-held biosciences company. Your audit firm engaged a business valuation specialist to assist in evaluating the client’s estimation of the investment’s fair value. You conclude that the valuation specialist’s work provides sufficient appropriate audit evidence.

6. Four weeks after the year-end date, a major customer of Prince Construction Co. declared bankruptcy. Because the customer had confirmed the balance due to Prince

*AICPA adapted.

Part 1 / THE AUDITING PROFESSION

70

at the balance sheet date, management refuses to charge off the account or otherwise disclose the information. The receivable represents approximately 10% of accounts receivable and 20% of net earnings before taxes.

For each situation, do the following:

a. Identify which of the conditions requiring a modification of or a deviation from an unqualified standard report is applicable.

b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

c. Given your answers in parts a and b, state the type of audit report that should be issued. If you have not decided on one level of materiality in part b, state the appropriate report for each alternative materiality level.

3-29 (Objectives 3-4, 3-5, 3-6, 3-7, 3-8) For the following independent situations, assume that you are the audit partner on the engagement:

1. In the last 3 months of the current year, Oil Refining Company decided to change direction and go significantly into the oil drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its exist- ing refining business, but there are significant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no suc- cesses. The facts are adequately disclosed in footnotes.

2. Your client, Harrison Automotive, has changed from straight-line to sum-of-the- years’ digits depreciation. The effect on this year’s income is immaterial, but the effect in future years is likely to be material. The facts are adequately disclosed in footnotes.

3. Toronto Technology Corporation has prepared financial statements but has decided to exclude the statement of cash flows. Management explains to you that the users of their financial statements find this statement confusing and prefer not to have it included.

Required

4. Marseilles Fragrance, Inc. is based in New York but has operations throughout

Europe. Because users of the audited financial statement are international, your audit firm was engaged to conduct the audit in accordance with U.S. auditing standards and International Standards on Auditing (ISAs).

5. The controller of Brentwood Industries, Inc. will not allow you to confirm the receivable balance from two of its major customers. The amounts of the receivables are material in relation to Brentwood Industries’ financial statements. You are unable to satisfy yourself as to the receivable balances by alternative procedures.

6. Approximately 20% of the audit of Lumberton Farms, Inc. was performed by a different CPA firm, selected by you. You have reviewed their audit files and believe they did an excellent job on their portion of the audit. Nevertheless, you are unwilling to take complete responsibility for their work.

For each situation, do the following:

a. Identify which of the conditions requiring a modification of or a deviation from an unqualified standard report is applicable.

b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

c. Given your answers in parts a and b, state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b, state the appropriate report for each alternative materiality level):

Required

(1) Unqualified—standard wording

(2) Unqualified—explanatory paragraph (3) Unqualified—modified wording

(4) Qualified opinion only

(5) Qualified scope and opinion (6) Disclaimer

(7) Adverse*

*AICPA adapted.

Chapter 3 / AUDIT REPORTS 71

 

d. Based on your answer to part c, indicate which paragraphs, if any, should be modified in the standard audit report. Also indicate whether an additional paragraph is necessary and its location in the report.

3-30 (Objectives 3-4, 3-5, 3-7, 3-8) Several types of opinions are described in a. through i. below. For each opinion, select the appropriate description of that opinion from the list numbered 1 through 9 below that corresponds with the type of opinion.

Types of Opinion

a. Unqualified opinion with an explanatory paragraph for change in consistency

b. Disclaimer of opinion due to scope limitation

c. Qualified opinion due to inadequate disclosure; report includes a going concern

explanatory paragraph

d. Shared report with other auditors

e. Standard unqualified (“clean”) opinion

f. Qualified opinion due to a scope limitation

g. Adverse opinion for departure from accounting standards

h. Disclaimer of opinion due to lack of independence

i. Unqualified opinion with an explanatory paragraph for a change in consistency and an explanatory paragraph for an emphasis of a matter

Description of Opinions (each item in list can be used only once)

1. One paragraph report containing the words “we do not express an opinion”

2. Three paragraph report with no changes in wording

3. Three paragraph report; the wording in all three paragraphs has been modified

4. Three paragraph report in which the opinion includes “we do not express an opinion”

5. Four paragraph report in which the explanatory fourth paragraph precedes the

opinion; opinion includes “except for the effects of such adjustments, if any, as might

have been determined had we been able to examine”

6. Four paragraph report in which the explanatory fourth paragraph precedes the

opinion; opinion includes “financial statements do not present fairly”

7. Four paragraph report in which the explanatory fourth paragraph follows the opinion 8. Five paragraph report with explanatory paragraphs preceding and following the opinion 9. Five paragraph report with two explanatory paragraphs following the opinion

3-31 (Objective 3-4) Various types of “accounting changes” can affect the second reporting standard of the generally accepted auditing standards. This standard reads, “The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.” Assume that the following list describes changes that have a material effect on a client’s financial statements for the current year:

1. Correction of a mathematical error in inventory pricing made in a prior period.

2. A change from deferring and amortizing preproduction costs to recording such costs as an expense when incurred because future benefits of the costs have become doubtful. The new accounting method was adopted in recognition of the change in estimated

future benefits.

3. A change from the completed-contract method to the percentage-of-completion

method of accounting for long-term construction contracts.

4. A change in the estimated useful life of previously recorded fixed assets based on

newly acquired information

5. A change to including the employer share of Social Security (FICA) taxes as

“retirement benefits” on the income statement from including it with “other taxes.”

6. A change from prime costing to full absorption costing for inventory valuation.

7. A change from presentation of statements of individual companies to presentation

of consolidated statements.

8. A change from the FIFO method of inventory pricing to the LIFO method of

inventory pricing.

Part 1 / THE AUDITING PROFESSION

72

Identify the type of change described in each item above, and state whether any modi- fication is required in the auditor’s report as it relates to the second standard of reporting. Organize your answer sheet as shown. For example, a change from the LIFO method of inventory pricing to the FIFO method of inventory pricing would appear as shown.

Required

Assume that each item is material.*

Item No. Type of Change

Example An accounting change from one generally accepted accounting principle to another generally accepted

accounting principle

Should Auditor’s

Report Be Modified?

Yes

3-32 (Objectives 3-1, 3-2, 3-4) The following tentative auditor’s report was drafted by a staff accountant and submitted to a partner in the accounting firm of Better & Best, CPAs:

AUDIT REPORT

To the Audit Committee of American Broadband, Inc.

We have examined the consolidated balance sheets of American Broadband, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated state- ments of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our respon- sibility is to express an opinion on these financial statements based on our audits.

Our audits were made in accordance with auditing standards generally accepted in the United States of America as we considered necessary in the circumstances. Other auditors audited the financial statements of certain subsidiaries and have furnished us with reports thereon containing no exceptions. Our opinion expressed herein, insofar as it relates to the amounts included for those subsidiaries, is based solely upon the reports of the other auditors.

As fully discussed in Note 7 to the financial statements, in 2011, the company extended the use of the last-in, first-out (LIFO) method of accounting to include all

inventories. In examining inventories, we engaged Dr. Irwin Same (Nobel Prize win- ner 2009) to test check the technical requirements and specifications of certain items of equipment manufactured by the company.

In our opinion, the financial statements referred to above present fairly the finan- cial position of American Broadband, Inc. as of December 31, 2011, and the results of operations for the years then ended, in conformity with accounting principles gener- ally accepted in the United States of America.

To be signed by Better & Best, CPAs March 1, 2012

Identify deficiencies in the staff accountant’s tentative report that constitute departures from the generally accepted standards of reporting.*

3-33 (Objectives 3-1, 3-9) The following is an auditor’s report prepared in accordance with International Standards on Auditing (ISAs) issued by the International Auditing and Assurance Standards Board (IAASB):

INDEPENDENT AUDITOR’S REPORT

To the Shareholders of Les Meridian, Inc.

We have audited the accompanying financial statements of Les Meridian, Inc., which comprise the statement of financial position as of December 31, 2011, and the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory notes.

Required

*AICPA adapted.

Chapter 3 / AUDIT REPORTS 73

 

Required

Bergen and Bergen, CPAs February 20, 2012 19 Rue de Bordeaux Marseille, France

a. For each of the seven distinct parts of the standard unqualified report prepared in accordance with generally accepted auditing standards in the United States, describe whether key elements of each of those seven parts are present in the audit report based on International Standards on Auditing for Les Meridian’s financial statements.

b. Describe elements in the audit report based on International Standards on Auditing that are more extensive than an audit report based on U.S. auditing standards.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstate- ment of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presenta- tion of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements give a true and fair view of the financial

position of Les Meridian, Inc. as of December 31, 2011, and of its financial perfor-

mance and cash flows for the year then ended in accordance with International Financial Reporting Standards.

INTERNET PROBLEM 3-1: RESEARCH ANNUAL REPORTS

The U.S. Securities and Exchange Commission (SEC) is an independent, nonpartisan, quasi-judicial regulatory agency with responsibility for administering the federal securities laws. Publicly traded companies must electronically file a variety of forms or reports with the SEC (for example, annual financial statements). The SEC makes most of these electronic documents available on the Internet via EDGAR. EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval system. The primary purpose for EDGAR is to increase the efficiency and fairness of the securities market for the benefit of investors, corporations, and the economy by accelerating the receipt, acceptance, dissemination, and analysis of time-sensitive corporate information filed with the agency.

Chapter 4

4-1 (Objective 4-1) What are the six core ethical values described by the Josephson Institute? What are some other sources of ethical values?

4-2 (OAbjpectaivge 4o-2) DPesDcriFbe anEenthihcaal dnilecmmear. How does a person resolve an ethical dilemma?

4-3 (Objective 4-3) Why is there a special need for ethical behavior by professionals? Why do the ethical requirements of the CPA profession differ from those of other professions?

4-4 (Objective 4-4) List the four parts of the Code of Professional Conduct, and state the purpose of each.

4-5 (Objective 4-4) What organization is responsible for developing ethics standards at the international level? What are the fundamental principles of the international ethics standards?

4-6 (Objective 4-5) Distinguish between independence of mind and independence in appearance. State three activities that may not affect independence of mind but are likely to affect independence in appearance.

4-7 (Objective 4-5) Why is an auditor’s independence so essential?

4-8 (Objective 4-5) What consulting or nonaudit services are prohibited for auditors of public companies? What other restrictions and requirements apply to auditors when providing nonaudit services to public companies?

4-9 (Objective 4-6) Explain how the rules concerning stock ownership apply to partners and professional staff. Give an example of when stock ownership would be prohibited for each.

4-10 (Objective 4-5) Many people believe that a CPA cannot be truly independent when payment of fees is dependent on the management of the client. Explain two approaches that could reduce this appearance of lack of independence.

4-11 (Objective 4-7) After accepting an engagement, a CPA discovers that the client’s industry is more technical than he realized and that he is not competent in certain areas of the operation. What are the CPA’s options?

Part 1 / THE AUDITING PROFESSION

104

4-12 (Objective 4-7) Assume that an auditor makes an agreement with a client that the audit fee will be contingent upon the number of days required to complete the engagement. Is this a violation of the Code of Professional Conduct? What is the essence of the rule of professional ethics dealing with contingent fees, and what are the reasons for the rule?

4-13 (Objective 4-7) The auditor’s audit files usually can be provided to someone else only with the permission of the client. Give three exceptions to this general rule.

4-14 (Objective 4-7) Identify and explain factors that should keep the quality of audits high even though advertising and competitive bidding are allowed.

4-15 (Objective 4-7) Summarize the restrictions on advertising by CPA firms in the rules of conduct and interpretations.

4-16 (Objective 4-7) What is the purpose of the AICPA’s Code of Professional Conduct restriction on commissions as stated in Rule 503?

4-17 (Objective 4-7) State the allowable forms of organization a CPA firm may assume. MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

4-18 (Objective 4-6) The following questions concern independence and the Code of Professional Conduct or GAAS. Choose the best response.

a. What is the meaning of the generally accepted auditing standard that requires the auditor be independent?

(1) The auditor must be without bias with respect to the client under audit.

(2) The auditor must adopt a critical attitude during the audit.

(3) The auditor’s sole obligation is to third parties.

(4) Theauditormayhaveadirectownershipinterestintheclient’sbusinessifitisnot

material.

b. The independent audit is importAanpt toaregadoers oPf fiDnaFncialEstantehmeantns bcecaeusre it

(1) determines the future stewardship of the management of the company whose

financial statements are audited.

(2) measures and communicates financial and business data included in financial

statements.

(3) involves the objective examination of and reporting on management-prepared

statements.

(4) reports on the accuracy of all information in the financial statements.

c. An auditor strives to achieve independence in appearance to

(1) maintain public confidence in the profession.

(2) become independent in fact.

(3) comply with the generally accepted auditing standards of field work. (4) maintain an unbiased mental attitude.

4-19 (Objective 4-7) The following questions concern possible violations of the AICPA Code of Professional Conduct. Choose the best response.

a. In which one of the following situations would a CPA be in violation of the AICPA Code of Professional Conduct in determining the audit fee?

(1) AfeebasedonwhethertheCPA’sreportontheclient’sfinancialstatementsresults

in the approval of a bank loan.

(2) A fee based on the outcome of a bankruptcy proceeding.

(3) A fee based on the nature of the service rendered and the CPA’s expertise instead

of the actual time spent on the engagement.

(4) A fee based on the fee charged by the prior auditor.

b. The AICPA Code of Professional Conduct states that a CPA shall not disclose any confidential information obtained in the course of a professional engagement except with the consent of the client. In which one of the following situations would disclosure by a CPA be in violation of the code?

Chapter 4 / PROFESSIONAL ETHICS

105

(1) Disclosing confidential information in order to properly discharge the CPA’s responsibilities in accordance with the profession’s standards.

(2) Disclosing confidential information in compliance with a subpoena issued by a court.

(3) Disclosing confidential information to another accountant interested in pur- chasing the CPA’s practice.

(4) Disclosing confidential information during an AICPA authorized peer review.

c. A CPA’s retention of client records as a means of enforcing payment of an overdue audit fee is an action that is

(1) not addressed by the AICPA Code of Professional Conduct.

(2) acceptable if sanctioned by the state laws.

(3) prohibited under the AICPA rules of conduct.

(4) a violation of generally accepted auditing standards.

DISCUSSION QUESTIONS AND PROBLEMS

4-20 (Objectives 4-5, 4-6) The following situations involve the provision of nonaudit services. Indicate whether providing the service is a violation of AICPA rules or SEC rules including Sarbanes–Oxley requirements on independence. Explain your answer as necessary.

a.

b. c.

d.

e.

f .

Providing bookkeeping services to a public company. The services were preapproved by the audit committee of the company.

Providing internal audit services to a public company that is not an audit client.

Implementing a financial information system designed by management for a private company.

Recommending a tax shelter to a client that is publicly held. The services were pre- approved by the audit committee.

PArovpidainginoternaPl aDudFit serEvicneshtoa pnubclicecormpany audit client with the preapproval of the audit committee.

Providing bookkeeping services to an audit client that is a private company.

4-21 (Objectives 4-6, 4-7) Each of the following situations involves a possible violation of the AICPA’s Code of Professional Conduct. For each situation, state the applicable section of the rules of conduct and whether it is a violation.

a. Emrich, CPA, provides tax services, management advisory services, and bookkeeping services and conducts audits for the same nonpublic client. Because the firm is small, the same person often provides all the services.

b. Franz Marteens is a CPA, but not a partner, with 3 years of professional experience with Roberts and Batchelor, CPAs. He owns 25 shares of stock in an audit client of the firm, but he does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth.

c. A nonaudit client requests assistance of M. Wilkenson, CPA, in the installation of a local area network. Wilkenson had no experience in this type of work and no knowledge of the client’s computer system, so he obtained assistance from a computer consultant. The consultant is not in the practice of public accounting, but Wilkenson is confident of his professional skills. Because of the highly technical nature of the work, Wilkenson is not able to review the consultant’s work.

d. In preparing the personal tax returns for a client, Sarah Milsaps, CPA, observed that the deductions for contributions and interest were unusually large. When she asked the client for backup information to support the deductions, she was told, “Ask me no questions, and I will tell you no lies.” Milsaps completed the return on the basis of the information acquired from the client.

e. Roberta Hernandez, CPA, serves as controller of a U.S. based company that has a significant portion of its operations in several South American countries. Certain

Part 1 / THE AUDITING PROFESSION

106

government provisions in selected countries require the company to file financial statements based on international standards. Roberta oversees the issuance of the company’s financial statements and asserts that the statements are based on inter- national financial accounting standards; however the standards she uses are not those issued by the International Accounting Standards Board.

f . Steve Custer, CPA, set up a casualty and fire insurance agency to complement his auditing and tax services. He does not use his own name on anything pertaining to the insurance agency and has a highly competent manager, Jack Long, who runs it. Custer often requests Long to review the adequacy of a client’s insurance with management if it seems underinsured. He believes that he provides a valuable service to clients by informing them when they are underinsured.

g. Seven small Seattle CPA firms have become involved in an information project by taking part in an interfirm working paper review program. Under the program, each firm designates two partners to review the audit files, including the tax returns and the financial statements of another CPA firm taking part in the program. At the end of each review, the auditors who prepared the working papers and the reviewers have a conference to discuss the strengths and weaknesses of the audit. They do not obtain authorization from the audit client before the review takes place.

h. Archer Ressner, CPA, stayed longer than he should have at the annual Christmas party of Ressner and Associates, CPAs. On his way home he drove through a red light and was stopped by a police officer, who observed that he was intoxicated. In a jury trial, Ressner was found guilty of driving under the influence of alcohol. Because this was not his first offense, he was sentenced to 30 days in jail and his driver’s license was revoked for 1 year.

4-22 (Objectives 4-6, 4-7) Each of the following situations involves possible violations of the AICPA’s Code of Professional Conduct. For each situation, state whether it is a violation of the Code. In those cases in which it is a violation, explain the nature of the violation and the rationale for the existing rule.

a. The audit firm of Miller and Yancy, CPAs has joined an association of other CPA firms

across the country to enhance the types of professional services the firm can provide. Miller and Yancy share resources with other firms in the association, including audit methodologies and audit manuals, and common IT systems for billing and time reporting. One of the partners in Miller and Yancy has a direct financial interest in the audit client of another firm in the association.

b. Bruce Sullivan, CPA, is the audit partner on the engagement of Xylium Corporation, which is a public company. In structuring the agreement with the audit committee for the audit of Xylium’s financial statements, Sullivan included a clause that limits the liability of Sullivan’s firm so that shareholders of Xylium are prohibited from suing Sullivan and the firm for performance issues related to the audit.

c. Jennifer Crowe’s audit client has a material investment in Polex, Inc. Jennifer’s non- dependent parents also own shares in Polex and Polex is not an attest client of Jennifer’s firm. The amount of her parent’s ownership in Polex is not significant to Jennifer’s net worth.

d. Joe Stokely is a former partner in Bass and Sims, CPAs. Recently, Joe left the firm to become the chief operating officer of Lacy Foods, Inc., which is an audit client of Bass and Sims. In his new role, Joe has no responsibilities for financial reporting. Bass and Sims made significant changes to the audit plan for the upcoming audit.

e. Odonnel Incorporated has struggled financially and has been unable to pay the audit fee to its auditor, Seale and Seale, CPAs, for the 2009 and 2010 audits. Seale and Seale is currently planning the 2011 audit.

f. Connor Bradley is the partner in charge of the audit of Southern Pinnacle Bank. Bradley is in the process of purchasing a beach condo and has obtained mortgage financing from Southern Pinnacle.

g. Jessica Alma has been serving as the senior auditor on the audit of Carolina BioHealth, Inc. Because of her outstanding work, the head of internal audit at Carolina BioHealth

Chapter 4 / PROFESSIONAL ETHICS 107

 

Required

extended her an offer of employment to join the internal audit department as an audit manager. When the discussions with Carolina BioHealth began, Jessica informed her office’s managing partner and was removed from the audit engagement.

h. Lorraine Wilcox is a CPA and professor of accounting at a major state university. One of her former students recently sat for the Audit section of the CPA exam. One day, the student dropped by Lorraine’s office and told her about many of the questions and simulation content on the exam. Lorraine was grateful for the information, which will be helpful as she prepares the course syllabus for the next semester.

i . Audrey Glover is a financial analyst in the financial reporting department of Technologies International, a privately held corporation. Audrey was asked to prepare several journal entries for Technologies International related to transactions that have not yet occurred. The entries are reflected in financial statements that the company recently provided to the bank in connection with a loan outstanding due to the bank.

j . Austin and Houston, CPAs, is performing consulting services to help management of McAlister Global Services streamline its production operations. Austin and Houston structured the fee for this engagement to be a fixed percentage of costs savings that result once the new processes are implemented. Austin and Houston perform no other services for McAlister Global.

4-23 (Objective 4-5) The national stock exchanges require listed companies to have an independent audit committee.

a. Describe an audit committee.

b. What are the typical functions performed by an audit committee?

c. Explain how an audit committee can help an auditor be more independent.

d. Describe the nature of the audit firm’s communications with the audit committee regarding independence issues.

Required

of audit committee members is to reduce their exposure to legal liability. The committees will therefore recommend larger, more prestigious CPA firms, even if the cost is somewhat higher, to minimize the potential criticism of selecting an unquali- fied firm. Evaluate these comments.

4-24 (Objectives 4-5, 4-6) The following relate to auditors’ independence:

a. Why is independence so essential for auditors?

b. Compare the importance of independence of CPAs with that of other professionals, such as attorneys.

c. Explain the difference between independence in appearance and of mind.

d. Assume that a partner of a CPA firm owns two shares of stock of a large audit client on which he serves as the engagement partner. The ownership is an insignificant part of his total wealth.

(1) Has he violated the Code of Professional Conduct?

(2) Explain whether the ownership is likely to affect the partner’s independence of mind.

(3) Explain the reason for the strict requirements about stock ownership in the rules of conduct.

e. Discuss how each of the following could affect independence of mind and inde- pendence in appearance, and evaluate the social consequence of prohibiting auditors from doing each one:

(1) Owning stock in a client company

(2) Having bookkeeping services for an audit client performed by the same person who does the audit

(3) Having the annual audit performed by the same audit team, except for assistants, for 5 years in a row

(4) Having the annual audit performed by the same CPA firm for 10 years in a row

Part 1 / THE AUDITING PROFESSION

e. Some critics of audit committees believe that they bias companies in favor of larger and perhaps more expensive CPA firms. These critics contend that a primary concern

108

(5) Having management select the CPA firm

(6) Recommending adjusting entries to the client’s financial statements and

preparing financial statements, including footnotes, for the client

(7) Having management services for an audit client performed by individuals in a

department that is separate from the audit department

f . Which of (1) through (7) are prohibited by the AICPA Code of Professional Conduct? Which are prohibited by the Sarbanes–Oxley Act or the SEC?

4-25 (Objective 4-6) Marie Janes encounters the following situations in doing the audit of a large auto dealership. Janes is not a partner.

1. The sales manager tells her that there is a sale (at a substantial discount) on new cars that is limited to long-established customers of the dealership. Because her firm has been doing the audit for several years, the sales manager has decided that Janes should also be eligible for the discount.

2. The auto dealership has an executive lunchroom that is available free to employees above a certain level. The controller informs Janes that she can also eat there any time.

3. Janes is invited to and attends the company’s annual Christmas party. When presents are handed out, she is surprised to find her name included. The present has a value

of approximately $200.

Use the three-step process in the AICPA’s independence conceptual framework to assess whether Janes’ independence has been impaired.

a. Describe how each of the situations might threaten Janes’ independence from the auto dealership.

b. Identify a safeguard that Janes’ firm could impose that would eliminate or mitigate the threat of each situation to Janes’ independence.

c. Assuming no safeguards are in place and Janes accepts the offer or gift in each situation, discuss whether she has violated the rules of conduct.

Required

d. Discuss what Janes should do in each situation.

4-26 (Objective 4-6) Ann Archer serves on the audit committee of JKB Communications, Inc., a telecommunications start-up company. The company is currently a private company. One of the audit committee’s responsibilities is to evaluate the external auditor’s inde- pendence in performing the audit of the company’s financial statements. In conducting this year’s evaluation, Ann learned that JKB Communications’ external auditor also performed the following IT and e-commerce services for the company:

1. Installed JKB Communications’ information system hardware and software selected by JKB management.

2. Supervised JKB Communications’ personnel in the daily operation of the newly installed information system.

3. Customized a prepackaged payroll software application, based on options and speci- fications selected by management.

4. Trained JKB Communications’ employees on the use of the newly installed informa- tion system.

5. Determined which JKB Communications’ products would be offered for sale on the company’s Internet Web site.

6. Operated JKB Communications’ local area network for several months while the company searched for a replacement after the previous network manager left the company.

Consider each of the preceding services separately. Evaluate whether the performance of each service violates the AICPA’s Code of Professional Conduct.

Required

CASES

4-27 (Objectives 4-6, 4-7) The following are situations that may violate the Code of Professional Conduct. Assume, in each case, that the CPA is a partner.

Chapter 4 / PROFESSIONAL ETHICS 109

 

Required

my banker, the government, and my CPA, but Finny’s the only one that is on my side.’’ Discuss whether the facts in any of the situations indicate violations of the Code of

1. Contel, CPA, advertises in the local paper that his firm does the audit of 14 of the 36 largest community banks in the state. The advertisement also states that the average audit fee, as a percentage of total assets for the banks he audits, is lower than any other CPA firm’s in the state.

2. Davis, CPA, sets up a small loan company specializing in loans to business executives and small companies. Davis does not spend much time in the business because he spends full time with his CPA practice. No employees of Davis’s CPA firm are involved in the small loan company.

3. Elbert, CPA, owns a material amount of stock in a mutual fund investment company, which in turn owns stock in Elbert’s largest audit client. Reading the investment company’s most recent financial report, Elbert is surprised to learn that the company’s ownership in his client has increased dramatically.

4. Able, CPA, owns a substantial limited partnership interest in an apartment building. Frederick Marshall is a 100% owner in Marshall Marine Co. Marshall also owns a substantial interest in the same limited partnership as Able. Able does the audit of Marshall Marine Co.

5. Baker, CPA, approaches a new audit client and tells the president that he has an idea that could result in a substantial tax refund in the prior year’s tax return by appli- cation of a technical provision in the tax law that the client had overlooked. Baker adds that the fee will be 50% of the tax refund after it has been resolved by the Internal Revenue Service. The client agrees to the proposal.

6. Finigan, CPA, does the audit, tax return, bookkeeping, and management services work for Gilligan Construction Company. Mildred Gilligan follows the practice of calling Finigan before she makes any major business decision to determine the effect on her company’s taxes and the financial statements. Finigan attends continuing education courses in the construction industry to make sure that she is technically competent and knowledgeable about the industry. Finigan normally attends board of directors meetings and accompanies Gilligan when she is seeking loans. Mildred Gilligan often

jokingly introduces Finigan with this statement, “I have my three business partners—

Professional Conduct. If so, identify the nature of the violation(s).

4-28 (Objectives 4-2, 4-7) Barbara Whitley had great expectations about her future as she sat in her graduation ceremony in May 2010. She was about to receive her Master of Accountancy degree, and next week she would begin her career on the audit staff of Green, Thresher & Co., CPAs.

Things looked a little different to Barbara in February 2011. She was working on the audit of Delancey Fabrics, a textile manufacturer with a calendar year-end. The pressure was enormous. Everyone on the audit team was putting in 70-hour weeks, and it still looked as if the audit wouldn’t be done on time. Barbara was doing work in the property area, vouching additions for the year. The audit program indicated that a sample of all items over $20,000 should be selected, plus a judgmental sample of smaller items. When Barbara went to take the sample, Jack Bean, the senior, had left the client’s office and couldn’t answer her questions about the appropriate size of the judgmental sample. Barbara forged ahead with her own judgment and selected 50 smaller items. Her basis for doing this was that there were about 250 such items, so 50 was a reasonably good proportion of such additions.

Barbara audited the additions with the following results: The items over $20,000 contained no misstatements; however, the 50 small items contained a large number of misstatements. In fact, when Barbara projected them to all such additions, the amount seemed quite significant.

A couple of days later, Jack Bean returned to the client’s office. Barbara brought her work to Jack in order to apprise him of the problems she found and got the following response:

“Gosh, Barbara, why did you do this? You were only supposed to look at the items over $20,000 plus 5 or 10 little ones. You’ve wasted a whole day on that work, and we can’t afford to spend any more time on it. I want you to throw away the schedules where you tested the last 40 small items and forget you ever did them.”

Part 1 / THE AUDITING PROFESSION

110

When Barbara asked about the possible audit adjustment regarding the small items, none of which arose from the first 10 items, Jack responded, “Don’t worry, it’s not material anyway. You just forget it; it’s my concern, not yours.’’

a. In what way is this an ethical dilemma for Barbara?

b. Use the six-step approach discussed in the book to resolve the ethical dilemma.

4-29 (Objectives 4-1, 4-2, 4-3) In 2006, Arnold Diaz was a bright, upcoming audit manager in the South Florida office of a national public accounting firm. He was an excellent technician and a good “people person.” Arnold also was able to bring new business into the firm as the result of his contacts in the rapidly growing Hispanic business community.

Arnold was assigned a new client in 2007, XYZ Securities, Inc., a privately held broker–dealer in the secondary market for U.S. government securities. Neither Arnold nor anyone else in the South Florida office had broker–dealer audit experience. However, the AICPA and Arnold’s firm had audit aids for the industry, which Arnold used to get started.

Arnold was promoted to partner in 2007. Although this was a great step forward for him (he was a new staff assistant in 1998), Arnold was also under a great deal of pressure. Upon making partner, he was required to contribute capital to the firm. He also thought he must maintain a special image with his firm, with his clients, and within the Hispanic community. To accomplish this, Arnold maintained an impressive wardrobe, bought a BMW and a small speedboat, and traded up to a nicer house. He also entertained freely. Arnold financed much of this higher living with credit cards. He had six American Express and banking cards and ran up a balance of about $40,000.

After the audit was completed and before the 2008 audit was to begin, Arnold contacted Jack Oakes, the CFO of XYZ Securities, with a question. Arnold had noticed an anomaly in the financial statements that he couldn’t understand and asked Oakes for an explanation. Oakes’s reply was as follows:

“Arnold, the 2007 financial statements were materially misstated and you guys just

blew it. I thought you might realize this and call me, so here’s my advice to you. Keep

Required

your mouth shut. We’ll make up the loss we covered up last year, this year, and nobody

will ever know the difference. If you blow the whistle on us, your firm will know you screwed up, and your career as the star in the office will be down the tubes.”

Arnold said he’d think about this and get back to Oakes the next day. When Arnold called Oakes, he had decided to go along with him. After all, it would only be a “shift” of a loss between two adjacent years. XYZ is a private company and no one would be hurt or know the difference. In reality, only he was the person exposed to any harm in this situation, and he had to protect himself, didn’t he?

When Arnold went to XYZ to plan for the 2008 audit, he asked Oakes how things were going, and Oakes assured him they were fine. He then said to Oakes,

“Jack, you guys are in the money business, maybe you can give me some advice. I’ve run up some debts and I need to refinance them. How should I go about it?”

After some discussions, Oakes volunteered a “plan.” Oakes would give Arnold a check for $15,000. XYZ would request its bank to put $60,000 in an account in Arnold’s name and guarantee the loan security on it. Arnold would pay back the $15,000 and have $45,000 of refinancing. Arnold thought the plan was great and obtained Oakes’s check for $15,000.

During 2008 through 2010, three things happened. First, Arnold incurred more debts and went back to the well at XYZ. By the end of 2010, he had “borrowed” a total of $125,000. Second, the company continued to lose money in various “off-the-books” investment schemes. These losses were covered up by falsifying the results of normal operations. Third, the audit team, under Arnold’s leadership, “failed to find” the fraud and issued unqualified opinions.

In 2009, Oakes had a tax audit of his personal 2008 return. He asked Arnold’s firm to handle it, and the job was assigned to Bob Smith, a tax manager. In reviewing Oakes’s records, Smith found a $15,000 check payable from Oakes to Diaz. Smith asked to see Diaz and inquired about the check. Arnold somewhat broke down and confided in Smith about his problems. Smith responded by saying,

“Don’t worry Arnold, I understand. And believe me, I’ll never tell a soul.”

Chapter 4 / PROFESSIONAL ETHICS 111

 

Required

In 2010, XYZ’s continuing losses caused it to be unable to deliver nonexistent securities when requested by a customer. This led to an investigation and bankruptcy by XYZ. Losses totaled in the millions. Arnold’s firm was held liable, and Arnold was found guilty of conspiracy to defraud. He is still in prison today.

a. Try to put yourself in Arnold’s shoes. What would you have done (be honest with yourself now) when told of the material misstatement in mid-2008?

b. What do you think of Bob Smith’s actions to help Arnold?

c. Where does one draw the line between ethical and unethical behavior?

4-30 (Objective 4-2) Frank Dorrance, a senior audit manager for Bright and Lorren, CPAs, has recently been informed that the firm plans to promote him to partner within the next year or two if he continues to perform at the same high-quality level as in the past. Frank excels at dealing effectively with all people, including client personnel, professional staff, partners, and potential clients. He has recently built a bigger home for entertaining and has joined the city’s most prestigious golf and tennis club. He is excited about his future with the firm.

Frank has recently been assigned to the audit of Machine International, a large wholesale

company that ships goods throughout the world. It is one of Bright and Lorren’s most

prestigious clients. During the audit, Frank determines that Machine International uses a

method of revenue recognition called “bill and hold” that has been questioned by the SEC.

After considerable research, Frank concludes that the method of revenue recognition is not

appropriate for Machine International. He discusses the matter with the engagement

partner, who concludes that the accounting method has been used for more than 10 years

by the client and is appropriate, especially considering that the client does not file with the

SEC. The partner is certain the firm would lose the client if the revenue recognition

method is found inappropriate. Frank argues that the revenue recognition method was

appropriate in prior years, but the SEC ruling makes it inappropriate in the current year.

Frank recognizes the partner’s responsibility to make the final decision, but he feels

strongly enough to state that he plans to follow the requirements of auditing standards (AU

Required

The partner informs Frank that she is unwilling to permit such a statement because of the potential legal implications. However, she is willing to write a letter to Frank stating that she takes full responsibility for making the final decision if a legal dispute ever arises. She concludes by saying, “Frank, partners must act like partners, not like loose cannons trying to make life difficult for their partners. You have some growing up to do before I would feel comfortable with you as a partner.’’

Use the six-step approach discussed in the book to resolve the ethical dilemma.

311) and include a statement in the audit files that he disagrees with the partner’s decision.

INTERNET PROBLEM 4-1: IESBA CODE OF ETHICS

Required

The International Ethics Standards Board for Accountants (IESBA) Handbook of the Code of Ethics for Professional Accountants is available for free download from the IFAC website (www.ifac.org). Similarly, the AICPA’s Code of Professional Conduct is searchable at the AICPA’s website (www.aicpa.org).

a. Locate both the IESBA Code and the AICPA Code on the respective websites.

b. Compare the six Principles in the AICPA Code with the five Fundamental Principles in the IESBA Code. Evaluate where there are similarities and differences in concepts across the principles.

c. One of the Principles in the AICPA Code is “public interest.” Describe how the IESBA Code addresses the concept of “public interest.”

d. Compare the organizational structure of the AICPA Code with the IESBA Code. e. Identify where in the IESBA Code issues related to independence are addressed.

Chapter 5

REVIEW QUESTIONS

5-1 (Objective 5-1) State several factors that have affected the incidence of lawsuits against CPAs in recent years.

5-2 (Objective 5-1) Lawsuits against CPA firms continue to increase. State your opinion of the positive and negative effects of the increased litigation on CPAs and on society as a whole.

5-3 (Objective 5-2) Distinguish between business failure and audit risk. Why is business failure a concern to auditors?

5-4 (Objective 5-3) How does the prudent person concept affect the liability of the auditor? 5-5 (Objective 5-3) Distinguish between “fraud” and “constructive fraud.”

5-6 (Objectives 5-1, 5-8) Discuss why many CPA firms have willingly settled lawsuits out of court. What are the implications to the profession?

5-7 (Objective 5-4) A common type of lawsuit against CPAs is for the failure to detect a fraud. State the auditor’s responsibility for such discovery. Give authoritative support for your answer.

5-8 (Objectives 5-3, 5-4) What is meant by contributory negligence? Under what con- ditions will this likely be a successful defense?

5-9 (Objective 5-4) Explain how an engagement letter might affect an auditor’s liability to clients under common law.

5-10 (Objectives 5-4, 5-5) Compare and contrast traditional auditors’ legal responsibilities to clients and third-party users under common law. How has that law changed in recent years?

5-11 (Objective 5-5) Is the auditor’s liability affected if the third party was unknown rather than known? Explain.

5-12 (Objective 5-6) Contrast the auditor’s liability under the Securities Act of 1933 with that under the Securities Exchange AcAt opf 1a93g4.o   Enhancer

5-13 (Objectives 5-4, 5-5, 5-6, 5-7) Distinguish between the auditor’s potential liability to the client, liability to third parties under common law, civil liability under the securities laws, and criminal liability. Describe one situation for each type of liability in which the auditor can be held legally responsible.

5-14 (Objective 5-6) What potential sanctions does the SEC have against a CPA firm? 5-15 (Objective 5-8) In what ways can the profession positively respond to and reduce

liability in auditing?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

5-16 (Objectives 5-4, 5-5) The following questions concern CPA firms’ liability under common law. Choose the best response.

a. Sharp, CPA, was engaged by Peters & Sons, a partnership, to give an opinion on the financial statements that were to be submitted to several prospective partners as part of a planned expansion of the firm. Sharp’s fee was fixed on a per diem basis. After a period of intensive work, Sharp completed about half of the necessary field work. Then, because of unanticipated demands on his time by other clients, Sharp was forced to abandon the work. The planned expansion of the firm failed to materialize because the prospective partners lost interest when the audit report was not promptly available. Sharp offered to complete the task at a later date. This offer was refused. Peters & Sons suffered damages of $400,000 as a result. Under the circumstances, what is the probable outcome of a lawsuit between Sharp and Peters & Sons?

(1) Sharp will be compensated for the reasonable value of the services actually performed.

(2) Peters & Sons will recover damages for breach of contract.

Chapter 5 / LEGAL LIABILITY 133

(3) Peters & Sons will recover both punitive damages and damages for breach of contract.

(4) Neither Sharp nor Peters & Sons will recover against the other.

b. In a common law action against an accountant, lack of privity is a viable defense if the plaintiff

(1) is the client’s creditor who sues the accountant for negligence.

(2) canprovethepresenceofgrossnegligencethatamountstoarecklessdisregardfor

the truth.

(3) is the accountant’s client.

(4) bases the action upon fraud.

c. The 1136 Tenants case was important chiefly because of its emphasis on the legal liability of the CPA when associated with

(1) an SEC engagement.

(2) unaudited financial statements.

(3) an audit resulting in a disclaimer of opinion. (4) letters for underwriters.

5-17 (Objective 5-6) The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response.

a. Major, Major, & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if

(1) the misstatements were caused primarily by MacLain.

(2) itcanbeshownthatatleastsomeoftheinvestorsdidnotactuallyreadtheaudited

(3) it can prove due diligence in the audit of the financial statements of MacLain.

(4) MacLain had expressly assumed any liability in connection with the public

offering.

b. Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security?

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

Reliance on the

Financial Statements

Yes Yes No No

Fraud by

The CPA

Yes No Yes No

financial statements.

Part 1 / THE AUDITING PROFESSION

c. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc. to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds’ best defense?

(1) They did not intentionally certify false financial statements.

(2) Section 10b does not apply to them.

(3) They were not in privity of contract with the creditors.

(4) Their engagement letter specifically disclaimed any liability to any party that

resulted from Markum’s fraudulent conduct.

d. Which of the following statements about the Securities Act of 1933 is not true?

(1) The third party user does not have the burden of proof that she/he relied on the

financial statements.

134

(2) The third party has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.

(3) Thethirdpartyuserdoesnothavetheburdenofproofthatthelosswascausedby the misleading financial statements.

(4) The auditor will not be liable if he or she can demonstrate due diligence in performing the audit.

DISCUSSION QUESTIONS AND PROBLEMS

5-18 (Objectives 5-3, 5-4, 5-5, 5-6) Following are 8 statements with missing terms involving auditor legal liability.

1. Under the Ultramares Doctrine, an auditor is generally not liability for _____ to third parties lacking _____.

2. The auditor will use a defense of _____ in a suit brought under the 1933 Securities Act.

3. After passage of the Private Securities Litigation Reform Act, auditors generally have _____ liability in federal securities cases.

4. The broadest class of third parties under common law is known as _____.

5. Based on the ruling in Hochfelder v. Ernst & Ernst, an auditor generally must have knowledge and _____ to be found guilty of a violation of Rule 10b-5 of the 1934 Act.

6. Under the 1933 Act, plaintiffs do not have to demonstrate _____ , but need merely demonstrate the existence of a _____.

7. _____ is generally only available as a defense in suits brought by clients.

8. A third party lacking privity will often be successful in bringing a claim against the auditor if they can demonstrate_____ or _____.

Terms

a. Due diligence    g.PInDteFnt toEdenceihveancer

b. Reliance on the financial statements

c. Fraud

d. Ordinary negligence

e. Separate and proportionate

f. Contributorynegligence

h. Privity of contract

i. Gross negligence

j. Foreseen users

k. Material error or omission

For each of the 11 blanks in statements 1 through 8, identify the most appropriate term. No term can be used more than once.

5-19 (Objectives 5-4, 5-5) Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm’s in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work.

A significant part of the audit entailed verifying the physical count, cost, and summari- zation of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart’s inventory count procedures, Yost told the president she believed the method of counting inventory at different locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president would sign a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations.

Eighteen months later, Yost found out that the worst had happened. Management below the president’s level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstate- ment occurred by physically transporting inventory at night to other locations after it had

Required

Chapter 5 / LEGAL LIABILITY 135

 

Required

been counted in a given location. The accounting records were inadequate to uncover these illegal transfers.

Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co. Answer the following questions, setting forth reasons for any conclusions stated:

a. What defense should Lauren Yost & Co. use in the suit by Stuart?

b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?

c. Is Yost likely to be successful in her defenses?

d. Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934?

5-20 (Objective 5-5) The CPA firm of Bigelow, Barton, and Brown was expanding rapidly. Consequently, it hired several junior accountants, including a man named Small. The partners of the firm eventually became dissatisfied with Small’s production and warned him they would be forced to discharge him unless his output increased significantly.

At that time, Small was engaged in audits of several clients. He decided that to avoid being fired, he would reduce or omit some of the standard auditing procedures listed in audit programs prepared by the partners. One of the CPA firm’s clients, Newell Corporation, was in serious financial difficulty and had adjusted several of the accounts being audited by Small to appear financially sound. Small prepared fictitious audit documentation in his home at night to support purported completion of auditing procedures assigned to him, although he in fact did not examine the adjusting entries. The CPA firm rendered an unqualified opinion on Newell’s financial statements, which were grossly misstated. Several creditors, relying on the audited financial statements, subsequently extended large sums of money to Newell Corporation.

Required

Will the CPA firm be liable to the creditors who extended the money because of their reliance on the erroneous financial statements if Newell Corporation should fail to pay them? Explain.*

Required

5-21 (Objectives 5-3, 5-5) Doyle and Jensen, CPAs, audited the accounts of Regal Jewelry, Inc., a corporation that imports and deals in fine jewelry. Upon completion of the audit, the auditors supplied Regal Jewelry with 20 copies of the audited financial statements. The firm knew in a general way that Regal Jewelry wanted that number of copies of the auditor’s report to furnish to banks and other potential lenders.

The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Regal Jewelry had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting jewelry listed as inventory when in fact Regal Jewelry had only empty boxes. The audit failed to detect these fraudulent entries. Thompson, relying on the audited financial statements, loaned Regal Jewelry $200,000. She seeks to recover her loss from Doyle and Jensen.

State whether each of the following is true or false and give your reasons:

a. If Thompson alleges and proves negligence on the part of Doyle and Jensen, she will be able to recover her loss.

b. If Thompson alleges and proves constructive fraud (that is, gross negligence on the part of Doyle and Jensen), she will be able to recover her loss.

c. Thompson does not have a contract with Doyle and Jensen.

d. Unless actual fraud on the part of Doyle and Jensen can be shown, Thompson can not recover.

e. Thompson is a third-party beneficiary of the contract Doyle and Jensen made with Regal Jewelry.*

*AICPA adapted.

Part 1 / THE AUDITING PROFESSION

136

5-22 (Objectives 5-5, 5-6) In order to expand its operations, Barton Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from First National Bank. In connection with this financing, Barton engaged Hanover & Co., CPAs to audit Barton’s financial statements. Hanover knew that the sole purpose of the audit was so that Barton would have audited financial statements to provide to First National Bank and the purchasers of the common stock. Although Hanover conducted the audit in conformity with its audit program, Hanover failed to detect material acts of embezzlement committed by Barton Corp.’s president. Hanover did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement.

After completing the engagement, Hanover issued an unqualified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, First National Bank approved the loan to Barton based on the audited financial statements. Within sixty days after the sale of the common stock and the issuance of the loan, Barton was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Barton became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Hanover by:

• The purchasers of the common stock who have asserted that Hanover is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

• First National Bank, based upon Hanover’s negligence.

• Trade creditors who extended credit to Barton, based upon Hanover’s negligence.

a. Discuss whether you believe Hanover will be found liable to the purchasers of common stock.

b. Indicate whether you believe First National Bank will be successful in its claim against Hanover.

c. Indicate whether you believe the trade creditors will be successful in their claim against Hanover.*

5-23 (Objectives 5-4, 5-5, 5-7) ChenA, CpPAa, gis tohe auPdDitoFr forEGrneehnleafnMcaneufracturing Corporation, a privately owned company that has a June 30 fiscal year. Greenleaf arranged for a substantial bank loan that was dependent on the bank’s receiving, by September 30, audited financial statements that showed a current ratio of at least 2 to 1. On September 25, just before the audit report was to be issued, Chen received an anonymous letter on Greenleaf’s stationery indicating that a 5-year lease by Greenleaf, as lessee, of a factory building accounted for in the financial statements as an operating lease was, in fact, a capital lease. The letter stated that there was a secret written agreement with the lessor modifying the lease and creating a capital lease.

Chen confronted the president of Greenleaf, who admitted that a secret agreement existed but said it was necessary to treat the lease as an operating lease to meet the current ratio requirement of the pending loan and that nobody would ever discover the secret agreement with the lessor. The president said that if Chen did not issue his report by September 30, Greenleaf would sue Chen for substantial damages that would result from not getting the loan. Under this pressure and because the audit files contained a copy of the 5-year lease agreement that supported the operating lease treatment, Chen issued his report with an unqualified opinion on September 29.

Despite the fact that the loan was received, Greenleaf went bankrupt within 2 years. The bank is suing Chen to recover its losses on the loan, and the lessor is suing Chen to recover uncollected rents.

Answer the following questions, setting forth reasons for any conclusions stated:

a. Is Chen liable to the bank?

b. Is Chen liable to the lessor?

c. Is there potential for criminal action against Chen?*

*AICPA adapted.

Required

Required

Chapter 5 / LEGAL LIABILITY 137

 

138

Required

5-24 (Objective 5-6) Under Section 11 of the Securities Act of 1933 and Section 10(b), Rule 10b-5, of the Securities Exchange Act of 1934, a CPA may be sued by a purchaser of registered securities. The following items relate to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA.

The plaintiff security purchaser must allege or prove:

1. Material misstatements were included in a filed document.

2. A monetary loss occurred.

3. Lack of due diligence by the CPA.

4. Privity with the CPA.

5. Reliance on the financial statements.

6. The CPA had scienter (knowledge and intent to deceive).

For each of the items 1 through 6 listed above, indicate whether the statement must be proven under

a. Section 11 of the Securities Act of 1933 only.

b. Section 10(b) of the Securities Exchange Act of 1934 only.

c. Both Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities

Exchange Act of 1934.

d. Neither Section 11 of the Securities Act of 1933 nor Section 10(b) of the Securities

Exchange Act of 1934.*

5-25 (Objective 5-6) Gordon & Groton, CPAs, were the auditors of Bank & Company, a brokerage firm and member of a national stock exchange. Gordon & Groton audited and reported on the financial statements of Bank, which were filed with the Securities and Exchange Commission.

Required

Answer the following questions, setting forth reasons for any conclusions stated: a. What is the probable outcome of the lawsuit?

b. What other theory of liability might the customers have asserted?*

5-26 (Objective 5-5) Sarah Robertson, CPA, had been the auditor of Majestic Co. for several years. As she and her staff prepared for the audit for the year ended December 31, 2010, Herb Majestic told her that he needed a large bank loan to “tide him over” until sales picked up as expected in late 2011.

In the course of the audit, Robertson discovered that the financial situation at Majestic was worse than Majestic had revealed and that the company was technically bankrupt. She discussed the situation with Majestic, who pointed out that the bank loan will “be his solution”—he was sure he will get it as long as the financial statements don’t look too bad.

Robertson stated that she believed the statements will have to include a going concern explanatory paragraph. Majestic said that this wasn’t needed because the bank loan was so certain and that inclusion of the going concern paragraph will certainly cause the manage- ment of the bank to change its mind about the loan.

Robertson finally acquiesced and the audited statements were issued without a going concern paragraph. The company received the loan, but things did not improve as Majestic thought they would and the company filed for bankruptcy in August 2011.

The bank sued Sarah Robertson for fraud.

Indicate whether or not you think the bank will succeed. Support your answer.

*AICPA adapted.

Required

Several of Bank’s customers were swindled by a fraudulent scheme perpetrated by Bank’s president, who owned 90% of the voting stock of the company. The facts establish that Gordon & Groton were negligent but not reckless or grossly negligent in the conduct of the audit, and neither participated in the fraudulent scheme or knew of its existence.

TheAcupstaomgeros arePsuDingFGorEdonh& Garnotocneunrder the antifraud provisions of Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934 for aiding and abetting the fraudulent scheme of the president. The customers’ suit for fraud is predicated exclusively on the nonfeasance of the auditors in failing to conduct a proper audit, thereby failing to discover the fraudulent scheme.

Part 1 / THE AUDITING PROFESSION

5-27 (Objectives 5-5, 5-6) Part 1. Whitlow & Company is a brokerage firm registered under the Securities Exchange Act of 1934. The act requires such a brokerage firm to file audited financial statements with the SEC annually. Mitchell & Moss, Whitlow’s CPAs, performed the annual audit for the year ended December 31, 2011, and rendered an unqualified opinion, which was filed with the SEC along with Whitlow’s financial statements. During 2011, Charles, the president of Whitlow & Company, engaged in a huge embezzlement scheme that eventually bankrupted the firm. As a result, substantial losses were suffered by cus- tomers and shareholders of Whitlow & Company, including Thaxton, who had recently purchased several shares of stock of Whitlow & Company after reviewing the company’s 2011 audit report. Mitchell & Moss’s audit was deficient; if they had complied with auditing standards, the embezzlement would have been discovered. However, Mitchell & Moss had no knowledge of the embezzlement, nor can their conduct be categorized as reckless.

Answer the following questions, setting forth reasons for any conclusions stated:

a. What liability to Thaxton, if any, does Mitchell & Moss have under the Securities

Exchange Act of 1934?

b. What theory or theories of liability, if any, are available to Whitlow & Company’s

customers and shareholders under common law?

Part 2. Jackson is a sophisticated investor. As such, she was initially a member of a small

group that was going to participate in a private placement of $1 million of common stock of

Clarion Corporation. Numerous meetings were held between management and the investor

group. Detailed financial and other information was supplied to the participants. Upon the

eve of completion of the placement, it was aborted when one major investor withdrew.

Clarion then decided to offer $2.5 million of Clarion common stock to the public pursuant

to the registration requirements of the Securities Act of 1933. Jackson subscribed to

Required

$300,000 of the Clarion public stock offering. Nine months later, Clarion’s earnings dropped

significantly, and as a result, the stock dropped 20% beneath the offering price. In addition, the Dow Jones Industrial Average was down 10% from the time of the offering.

Jackson sold her shares at a loss of $60,000 and seeks to hold all parties liable who participated in the public offering, including Clarion’s CPA firm of Allen, Dunn, and Rose. Although the audit was performed in conformity with auditing standards, there were some relatively minor misstatements. The financial statements of Clarion Corporation, which were part of the registration statement, contained minor misleading facts. It is believed by Clarion and Allen, Dunn, and Rose that Jackson’s asserted claim is without merit.

Answer the following questions, setting forth reasons for any conclusions stated:

a. If Jackson sues under the Securities Act of 1933, what will be the basis of her claim?

b. What are the probable defenses that might be asserted by Allen, Dunn, and Rose in

Required

light of these facts?*

CASE

INTERNET PROBLEM 5-1: SEC ENFORCEMENT

The SEC Enforcement Division investigates possible violations of securities laws, recom- mends SEC action when appropriate, either in a federal court or before an administrative law judge, and negotiates settlements. Litigation Releases, which are descriptions of SEC civil and selected criminal suits in the federal courts, are posted on the SEC web site (www.sec.gov/litigation/litreleases.shtml). Find Litigation Release No. 21532 dated May 25, 2010.

a. What is the nature of the complaint underlying LR No. 21532? Required

b. What sections of the federal securities laws is the individual involved accused of violating?

Chapter 6

REVIEW QUESTIONS

6-1 (Objective 6-1) State the objective of the audit of financial statements. In general terms, how do auditors meet that objective?

6-2 (Objectives 6-2, 6-3) Distinguish between management’s and the auditor’s responsi- bility for the financial statements being audited.

6-3 (Objective 6-3) Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each?

6-4 (Objective 6-3) Distinguish between fraudulent financial reporting and misappro- priation of assets. Discuss the likely difference between these two types of fraud on the fair presentation of financial statements.

6-5 (Objective 6-3) Because management operates the business on a daily basis, they know more about the company’s transactions and related assets, liabilities, and equity than the auditor. For example, it is extremely difficult, if not impossible, for the auditor to evaluate the obsolescence of inventory as well as management can in a highly complex business. Given these observations, evaluate the auditor’s responsibility for detecting material misrepresentations in the financial statements by management.

6-6 (Objective 6-3) List two major characteristics that are useful in predicting the likeli- hood 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.

6-7 (Objective 6-4) Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit into different cycles?

6-8 (Objective 6-4) Identify the cycle to which each of the following general ledger accounts will ordinarily be assigned: sales, accounts payable, retained earnings, accounts receivable, inventory, and repairs and maintenance.

6-9 (Objectives 6-4, 6-5) Why are sales, sales returns and allowances, bad debts, cash

discounts, accounts receivable, and allowance for uncollectible accounts all included in the same cycle?

6-10 (Objective 6-6) Define what is meant by a management assertion about financial statements. Identify the three broad categories of management assertions.

6-11 (Objectives 6-5, 6-6) Distinguish between the general audit objectives and manage- ment assertions. Why are the general audit objectives more useful to auditors?

6-12 (Objective 6-7) An acquisition of a 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?

6-13 (Objective 6-8) Distinguish between the existence and completeness balance-related audit objectives. State the effect on the financial statements (overstatement or under- statement) of a violation of each in the audit of accounts receivable.

6-14 (Objectives 6-7, 6-8, 6-9) What are specific audit objectives? Explain their relationship to the general audit objectives.

6-15 (Objectives 6-6, 6-8) Identify the management assertion and general balance-related audit objective for the specific balance-related audit objective: All recorded fixed assets exist at the balance sheet date.

6-16 (Objectives 6-6, 6-8) 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.

6-17 (Objectives 6-6, 6-9) Identify the management assertion and presentation and dis- closure-related audit objective for the specific presentation and disclosure-related audit objective: Read the fixed asset footnote disclosure to determine that the types of fixed assets, depreciation methods and useful lives are clearly disclosed.

Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 165

6-18 (Objective 6-10) Identify the four phases of the audit. What is the relationship of the four phases to the objective of the audit of financial statements?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

6-19 (Objective 6-1) The following questions concern the reasons auditors do audits. Choose the best response.

a. Which of the following best describes the reason why an independent auditor reports on financial statements?

(1) A misappropriation of assets may exist, and it is more likely to be detected by

independent auditors.

(2) Different interests may exist between the company preparing the statements and

the persons using the statements.

(3) A misstatement of account balances may exist and is generally corrected as the

result of the independent auditor’s work.

(4) Poorly designed internal controls may be in existence.

b. Because of the risk of material misstatement, an audit should be planned and per- formed with an attitude of

(1) objective judgment. (3) professional skepticism.

(2) independent integrity. (4) impartial conservatism.

c. The major reason an independent auditor gathers audit evidence is to (1) form an opinion on the financial statements.

(2) detect fraud.

(3) evaluate management.

(4) assess control risk.

6-20 (Objective 6-3) The following questions deal with errors and fraud. Choose the best

response.

a. An independent auditor has the responsibility to design the audit to provide reasonable assurance of detecting errors and fraud that might have a material effect on the financial statements. Which of the following, if material, is a fraud as defined in audit- ing standards?

(1) Misappropriation of an asset or groups of assets.

(2) Clerical mistakes in the accounting data underlying the financial statements.

(3) Mistakes in the application of accounting principles.

(4) Misinterpretationoffactsthatexistedwhenthefinancialstatementswereprepared.

b. What assurance does the auditor provide that errors, fraud, and direct-effect illegal acts that are material to the financial statements will be detected?

Errors Fraud Direct-Effect Illegal Acts

(1) Limited

(2) Reasonable

(3) Limited

(4) Reasonable

Negative Limited Reasonable Reasonable Limited Reasonable Limited Limited

Part 2 / THE AUDIT PROCESS

c. Which of the following statements describes why a properly designed and executed audit may not detect a material misstatement in the financial statements resulting from fraud?

(1) Auditproceduresthatareeffectivefordetectingunintentionalmisstatementsmay

be ineffective for an intentional misstatement that is concealed through collusion.

(2) An audit is designed to provide reasonable assurance of detecting material errors,

but there is no similar responsibility concerning fraud.

(3) The factors considered in assessing control risk indicated an increased risk of

intentional misstatements, but only a low risk of unintentional misstatements.

(4) The auditor did not consider factors influencing audit risk for account balances

that have effects pervasive to the financial statements taken as a whole.

166

6-21 (Objective 6-6) The following questions deal with management assertions. Choose the best response.

a. An auditor reviews aged accounts receivable to assess likelihood of collection to support management’s assertion about account balances of

(1) existence. (3) valuation and allocation.

(2) completeness. (4) rights and obligations.

b. An auditor will most likely review an entity’s periodic accounting for the numerical sequence of shipping documents to ensure all documents are included to support management’s assertion about classes of transactions of

(1) occurrence. (3) accuracy.

(2) completeness. (4) classification.

c . In the audit of accounts payable, an auditor’s procedures will most likely focus primarily on management’s assertion about account balances of

(1) existence. (3) valuation and allocation.

(2) completeness. (4) classification and understandability.

DISCUSSION QUESTIONS AND PROBLEMS

6-22 (Objectives 6-2, 6-3) The following are selected portions of the report of management from a published annual report.

REPORT OF MANAGEMENT

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of its President and Chief

Executive Officer and Chief Financial Officer to provide reasonable assurance regarding

the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting in accordance with accounting principles generally accepted in the United States of America. Management evaluates the effectiveness of the Company’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control–Integrated Framework. Management, under the supervision and with the participation of the Company’s President and Chief Executive Officer and Chief Financial Officer assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 and concluded it is effective.

Management’s Responsibility for Consolidated Financial Statements

The management of Colgate-Palmolive Company is also responsible for the preparation and content of the accompanying consolidated financial statements as well as all other related information contained in this annual report. These financial statements have been prepared in conformity with accounting principles generally accepted in the United States, and necessarily include amounts which are based on management’s best estimates and judgments.

a. What are the purposes of the two parts of the report of management?

b. What is the auditor’s responsibility related to the report of management?

6-23 (Objectives 6-1, 6-3) Auditors provide “reasonable assurance” that the financial state- ments are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.

a. Discuss the concept of “reasonable assurance” and the degree of confidence that financial statement users should have in the financial statements.

b. What are the responsibilities of the independent auditor in the audit of financial statements? Discuss fully, but in this part do not include fraud in the discussion.

Required

Required

Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 167

 

Required

a. Identify the accounts in the trial balance that are likely to be included in each trans- action cycle. Some accounts will be included in more than one cycle. Use the format that follows.

c. What are the responsibilities of the independent auditor for the detection of fraud involving misappropriation of assets and fraudulent financial reporting? Discuss fully, including your assessment of whether the auditor’s responsibility for the detection of fraud is appropriate.

6-24 (Objective 6-4) The following general ledger accounts are included in the trial balance for an audit client, Jones Wholesale Stationery Store.

Accounts payable

Accounts receivable Accrued interest expense Accrued sales salaries Accumulated depreciation—

furniture and equipment Advertising expense

Allowance for doubtful accounts Bad debt expense

Cash

Common stock

Depreciation expense—furniture

and equipment Furniture and equipment Income tax expense Income tax payable

Insurance expense Interest expense Inventory

Loans payable

Notes payable

Notes receivable—trade Prepaid insurance Property tax expense Property tax payable Purchases

Rent expense

Retained earnings

Salaries, office and general Sales

Sales salaries expense Telecommunications expense

Balance Sheet

Cycle Accounts

Sales and collection

Acquisition and payment

Income Statement

Accounts

 

Inventory and warehousing Capital acquisition and repayment

Payroll and personnel

Required

b. How will the general ledger accounts in the trial balance most likely differ if the company were a retail store rather than a wholesale company? How will they differ for a hospital or a government unit?

6-25 (Objective 6-6) The following are various management assertions (a through m) related to sales and accounts receivable.

Management Assertion

a. All sales transactions have been recorded.

b. Receivables are appropriately classified as to trade and other receivables in the

financial statements and are clearly described.

c. Accountsreceivablearerecordedatthecorrectamounts.

d. Salestransactionshavebeenrecordedintheproperperiod.

e. Salestransactionshavebeenrecordedintheappropriateaccounts.

f. Allrequireddisclosuresaboutsalesandreceivableshavebeenmade.

g. All accounts receivable have been recorded.

h. Therearenoliensorotherrestrictionsonaccountsreceivable.

i. Disclosuresrelatedtoreceivablesareatthecorrectamounts.

j. Recordedsalestransactionshaveoccurred.

k. Recordedaccountsreceivableexist.

l. Salestransactionshavebeenrecordedatthecorrectamounts.

m. Disclosuresrelatedtosalesandreceivablesrelatetotheentity.

a. Explain the differences among management assertions about classes of transactions and events, management assertions about account balances, and management assertions about presentation and disclosure.

Part 2 / THE AUDIT PROCESS

168

b. For each assertion, indicate whether it is an assertion about classes of transactions and events, an assertion about account balances, or an assertion about presentation and disclosure.

c. Indicate the name of the assertion made by management. (Hint: See Table 6-2 on page 154.)

6-26 (Objectives 6-6, 6-8) The following are specific balance-related audit objectives applied to the audit of accounts receivable (a through h) and management assertions about account balances (1 through 4). The list referred to in the specific balance-related audit objectives is the list of the accounts receivable from each customer at the balance sheet date.

Specific Balance-Related Audit Objective

a. There are no unrecorded receivables.

b. Receivableshavenotbeensoldordiscounted.

c. Uncollectible accounts have been provided for.

d. Receivablesthathavebecomeuncollectiblehavebeenwrittenoff.

e. Allaccountsonthelistareexpectedtobecollectedwithin1year.

f. Thetotaloftheamountsontheaccountsreceivablelistingagreeswiththegeneral ledger balance for accounts receivable.

g. Allaccountsonthelistarosefromthenormalcourseofbusinessandarenotdue from related parties.

h. Salescutoffatyear-endisproper.

Management Assertion about Account Balances

1. Existence 3. Valuationandallocation 2. Completeness 4. Rights and obligations

For each specific balance-related audit objective, identify the appropriate management assertion. (Hint: See Table 6-4 on page 160.)

Required

6-27 (Objectives 6-6, 6-7) The following are specific transaction-related audit objectives applied to the audit of cash disbursement transactions (a through f), management

a. b.

c. d. e. f .

Recorded cash disbursement transactions are for the amount of goods or services received and are correctly recorded.

Cash disbursement transactions are properly included in the accounts payable master file and are correctly summarized.

Recorded cash disbursements are for goods and services actually received. Cash disbursement transactions are properly classified.

Existing cash disbursement transactions are recorded.

Cash disbursement transactions are recorded on the correct dates.

Management Assertion about Classes of Transactions

1. Occurrence 2. Completeness 3. Accuracy

4. Classification 5. Cutoff

General Transaction-Related Audit Objective

6. Occurrence

7. Completeness

8. Accuracy

9. Postingandsummarization

10. Classification 11. Timing

assertions about classes of transactions (1 through 5), and general transaction-related audit objectives (6 through 11).

Specific Transaction-Related Audit Objective

a. Explain the differences among management assertions about classes of transactions and events, general transaction-related audit objectives, and specific transaction- related audit objectives and their relationships to each other.

b. For each specific transaction-related audit objective, identify the appropriate manage- ment assertion.

c. For each specific transaction-related audit objective, identify the appropriate general transaction-related audit objective.

Required

Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 169

 

Required

Required

6-28 (Objectives 6-6, 6-9) The following are specific presentation and disclosure-related audit objectives applied to presentation and disclosure for fixed assets (a through d) and management assertions (1 through 4).

Specific Presentation and Disclosure-Related Audit Objective

a. All required disclosures regarding fixed assets have been made.

b. Footnotedisclosuresrelatedtofixedassetsareclearandunderstandable.

c. Methodsandusefullivesdisclosedforeachcategoryoffixedassetareaccurate.

d. Disclosedfixedassetdispositionshaveoccurred.

Management Assertion about Presentation and Disclosure

1. Occurrenceandrightsandobligations 2. Completeness

3. Accuracyandvaluation

4. Classificationandunderstandability

For each specific presentation and disclosure-related audit objective, identify the appro- priate management assertion. (Hint: See Table 6-5 on page 161.)

6-29 (Objective 6-8) The following are two specific balance-related audit objectives in the audit of accounts payable. The list referred to is the list of accounts payable taken from the accounts payable master file. The total of the list equals the accounts payable balance on the general ledger.

1. All accounts payable included on the list represent amounts due to valid vendors. 2. There are no unrecorded accounts payable.

a. Explain the difference between these two specific balance-related audit objectives.

b. Which of these two specific balance-related audit objectives applies to the general balance-related audit objective of existence, and which one applies to completeness?

c. For the audit of accounts payable, which of these two specific balance-related audit objectives is usually more important? Explain.

6-30 (Objective 6-8) The following (1 through 18) are the balance-related, transaction-

related, and presentation and disclosure related audit objectives.

Balance-Related Transaction-Related Presentation and Dis- Audit Objectives Audit Objectives closure Audit Objectives

Required

Identify the specific audit objective (1-18) that each of the following specific audit pro- cedures (a. through l.) satisfies in the audit of sales, accounts receivable and cash receipts for fiscal year ended December 31, 2011.

Part 2 / THE AUDIT PROCESS

a. b. c .

d.

e.

Examine a sample of duplicate sales invoices to determine whether each one has a shipping document attached.

Add all customer balances in the accounts receivable trial balance and agree the amount to the general ledger.

For a sample of sales transactions selected from the sales journal, verify that the amount of the transaction has been recorded in the correct customer account in the accounts receivable subledger.

Inquire of the client whether any accounts receivable balances have been pledged as collateral on long-term debt and determine whether all required information is included in the footnote description for long-term debt.

For a sample of shipping documents selected from shipping records, trace each shipping document to a transaction recorded in the sales journal.

1. Existence 9.

Occurrence 15. Completeness

Accuracy 16. Classification 17. Timing

Occurrence and rights Completeness Accuracy and valuation Classification and understandability

2. Completeness 3. Accuracy

4. Classification 5. Cutoff

6. Detail tie-in

7. Realizable value

8. Rights and obligations

10. 11. 12. 13. 14.

Posting and summarization

18.

170

f .

g.

h.

i . j . k.

l .

Discuss with credit department personnel the likelihood of collection of all accounts as of December 31, 2011 with a balance greater than $100,000 and greater than 90 days old as of year end.

Examine sales invoices for the last five sales transactions recorded in the sales journal in 2011 and examine shipping documents to determine they are recorded in the correct period.

For a sample of customer accounts receivable balances at December 31, 2011, examine subsequent cash receipts in January 2012 to determine whether the customer paid the balance due.

Determine whether all risks related to accounts receivable are adequately disclosed. Foot the sales journal for the month of July and trace postings to the general ledger.

Send letters to a sample of accounts receivable customers to verify whether they have an outstanding balance at December 31, 2011.

Determine whether long-term receivables and related party receivables are reported separately in the financial statements.

6-31(Objective 6-10) Following are seven audit activities.

a. Examine invoices supporting recorded fixed asset additions.

b. Review industry databases to assess the risk of material misstatement in the financial statements.

c. Summarize misstatements identified during testing to assess whether the overall financial statements are fairly stated.

d. Test computerized controls over credit approval for sales transactions.

e. Send letters to customers confirming outstanding accounts receivable balances.

f. Perform analytical procedures comparing the client with similar companies in the industry to gain an understanding of the client’s business and strategies.

g. Compare information on purchases invoices recorded in the acquisitions journal with information on receiving reports.

For each activity listed above, indicate in which phase of the audit the procedure was likely performed.

Required

CASE

1. Plan and design an audit approach (Phase I)

2. Perform tests of controls and substantive tests of transactions (Phase II) 3. Perform analytical procedures and tests of details of balances (Phase III) 4. Complete the audit and issue an audit report (Phase IV)

6-32 (Objectives 6-1, 6-3) Rene Ritter opened a small grocery and related-products convenience store in 1989 with money she had saved working as an A&P store manager. She named it Ritter Dairy and Fruits. Because of the excellent location and her fine management skills, Ritter Dairy and Fruits grew to three locations by 1994. By that time, she needed additional capital. She obtained financing through a local bank at 2 percent above prime, under the condition that she submit quarterly financial statements reviewed by a CPA firm approved by the bank. After interviewing several firms, she decided to use the firm of Gonzalez & Fineberg CPAs, after obtaining approval from the bank.

In 1998, the company had grown to six stores, and Rene developed a business plan to add another 10 stores in the next several years. Ritter’s capital needs had also grown, so Rene decided to add two business partners who both had considerable capital and some expertise in convenience stores. After further discussions with the bank and continued conversations with the future business partners, she decided to have an annual audit and quarterly reviews done by Gonzalez & Fineberg, even though the additional cost was

Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 171

 

Required

almost $25,000 annually. The bank agreed to reduce the interest rate on the $4,000,000 of loans to 1 percent above prime.

By 2003, things were going smoothly, with the two business partners heavily involved in day-to-day operations and the company adding two new stores each year. The company was growing steadily and was more profitable than they had expected. By the end of 2002, one of the business partners, Fred Worm, had taken over responsibility for accounting and finance operations, as well as some marketing. Annually, Gonzalez & Fineberg did an in-depth review of the accounting system, including internal controls, and reported their conclusions and recommendations to the board of directors. Specialists in the firm provided tax and other advice. The other partner, Ben Gold, managed most of the stores and was primarily responsible for building new stores. Rene was president and managed four stores.

In 2008, the three partners decided to go public to enable them to add more stores and modernize existing ones. The public offering was a major success, resulting in $25 million in new capital and nearly 1,000 shareholders. Ritter Dairy and Fruits added stores rapidly under the three managers, and the company remained highly profitable under the leader- ship of Ritter, Worm, and Gold.

Rene retired in 2011 after a highly successful career. During the retirement celebration, she thanked her business partners, employees, and customers. She also added a special thanks to the bank management for their outstanding service and to Gonzalez & Fineberg for being partners in the best and most professional sense of the word. She mentioned their integrity, commitment, high-quality service in performing their audits and reviews, and considerable tax and business advice for more than two decades.

a. Explain why the bank imposed a requirement of a quarterly review of the financial statements as a condition of obtaining the loan at 2 percent above prime. Also explain why the bank didn’t require an audit and why the bank demanded the right to approve which CPA firm was engaged.

b. Explain why Ritter Dairy and Fruits agreed to have an audit performed rather than a review, considering the additional annual cost of $25,000.

c. What did Rene mean when she referred to Gonzalez & Fineberg as partners? Does the CPA firm have an independence problem?

d. What benefit does Gonzalez & Fineberg provide to stockholders, creditors, and management in performing the audit and related services?

e. What are the responsibilities of the CPA firm to stockholders, creditors, management, and other users?

INTERNET PROBLEM 6-1: INTERNATIONAL AND PCAOB AUDIT OBJECTIVES

Required

This problem requires you to access authoritative standards to compare the objective of an audit as defined by GAAS (www.aicpa.org) and International Standards on Auditing (ISA 200) (www.iaasb.org) and the objective of an audit of internal control over financial reporting as defined by PCAOB auditing standards (www.pcaobus.org).

a. Compare the objective of an audit under GAAS and International Standards on Auditing. Are there substantive differences in the objective of an audit as defined by these two standards?

b. What is the objective of an audit of internal control over financial reporting?

c. What defines whether financial statements are fairly stated, and what defines whether internal control is considered effective? Are they related?

Chapter 7

REVIEW QUESTIONS

7-1 (Objective 7-1) Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements.

7-2 (Objective 7-2) List the four major evidence decisions that must be made on every audit.

7-3 (Objective 7-2) Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully worded?

7-4 (Objective 7-2) Describe what is meant by an audit program for accounts receivable. What four things should be included in an audit program?

7-5 (Objective 7-3) Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced, that the financial statements are correct.

7-6 (Objective 7-3) 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?

7-7 (Objective 7-3) Identify the six characteristics that determine the reliability of evidence. For each characteristic, provide one example of a type of evidence that is likely to be reliable.

7-8 (Objective 7-4) List the eight types of audit evidence included in this chapter and give two examples of each.

7-9 (Objective 7-4) What are the characteristics of a confirmation? Distinguish between a confirmation and external documentation.

7-10 (Objective 7-4) Distinguish between internal documentation and external docu- mentation as audit evidence and give three examples of each.

7-11 (Objective 7-4) Explain the importance of analytical procedures as evidence in determining the fair presentation of the financial statements.

7-12 (Objective 7-4) Identify the most important reasons for performing analytical procedures.

7-13 (Objective 7-4) 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,

Chapter 7 / AUDIT EVIDENCE 197

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?

7-14 (Objective 7-4) Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce detailed substantive procedures.

7-15 (Objective 7-5) List the purposes of audit documentation and explain why each purpose is important.

7-16 (Objectives 7-5, 7-6) For how long does the Sarbanes–Oxley Act require auditors of public companies to retain audit documentation?

7-17 (Objective 7-6) 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, initials of the preparer, date of the preparation, and an index code.

7-18 (Objective 7-6) 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?

7-19 (Objective 7-6) Distinguish between the following types of current period sup- porting schedules and state the purpose of each: analysis, trial balance, and tests of reasonableness.

7-20 (Objective 7-6) Why is it essential that the auditor not leave questions or exceptions in the audit documentation without an adequate explanation?

7-21 (Objective 7-6) Define what is meant by a tick mark. What is its purpose?

7-22 (Objective 7-5) Who owns the audit files? Under what circumstances can they be used

by other people?

7-23 (Objective 7-7) How does the auditor read and evaluate information that is available only in machine-readable form?

7-24 (Objective 7-7) Explain the purposes and benefits of audit documentation software. MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

7-25 (Objectives 7-3, 7-4) The following questions concern persuasiveness of evidence. Choose the best response.

a. Which of the following types of documentary evidence should the auditor consider to be the most reliable?

(1) A sales invoice issued by the client and supported by a delivery receipt from an

outside trucker.

(2) Confirmation of an account payable balance mailed by and returned directly to

the auditor.

(3) A check, issued by the company and bearing the payee’s endorsement, that is

included with the bank statements mailed directly to the auditor.

(4) An audit schedule prepared by the client’s controller and reviewed by the client’s

treasurer.

b. Which of the following statements concerning audit evidence is true?

(1) To be appropriate, audit evidence should be either persuasive or relevant, but

need not be reliable.

(2) The measure of the quantity and quality of audit evidence lies in the auditor’s

judgment.

(3) The difficulty and expense of obtaining audit evidence concerning an account

balance is a valid basis for omitting the test.

(4) A client’s accounting records can be sufficient audit evidence to support the

financial statements.

Part 2 / THE AUDIT PROCESS

198

c. Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the least persuasive type of evidence?

(1) Vendor’s invoice

(2) Bank statement obtained from the client

(3) Computations made by the auditor (4) Prenumbered sales invoices

d. Which of the following presumptions is correct about the reliability of audit evidence?

(1) Information obtained indirectly from outside sources is the most reliable audit

evidence.

(2) Tobereliable,auditevidenceshouldbeconvincingratherthanmerelypersuasive.

(3) Reliabilityofauditevidencereferstotheamountofcorroborativeevidenceobtained.

(4) Effective internal control provides more assurance about the reliability of audit

evidence.

7-26 (Objectives 7-5, 7-6) The following questions concern audit documentation. Choose the best response.

a. Which of the following is not a primary purpose of audit documentation? (1) To coordinate the audit.

(2) To assist in preparation of the audit report.

(3) To support the financial statements.

(4) To provide evidence of the audit work performed.

b. During an audit engagement, pertinent data are compiled and included in the audit files. The audit files primarily are considered to be

(1) a client-owned record of conclusions reached by the auditors who performed the

engagement.

(2) evidence supporting financial statements.

(3) supportfortheauditor’srepresentationsastocompliancewithauditingstandards.

(4) a record to be used as a basis for the following year’s engagement.

c. Although the quantity, type, and content of audit documentation will vary with the circumstances, audit documentation generally will include the

(1) copies of those client records examined by the auditor during the course of the

engagement.

(2) evaluation of the efficiency and competence of the audit staff assistants by the

partner responsible for the audit.

(3) auditor’s comments concerning the efficiency and competence of client manage-

ment personnel.

(4) auditing procedures followed and the testing performed in obtaining audit

evidence.

d. The permanent file of an auditor’s working papers most likely would include copies of the

(1) lead schedule.

(2) attorney’s letters.

(3) bank statements.

(4) debt agreements.

DISCUSSION QUESTIONS AND PROBLEMS

7-27 (Objective 7-4) The following are examples of documentation typically obtained by auditors:

1. Vendors’ invoices

2. General ledger files

3. Bank statements

4. Cancelled payroll checks

Chapter 7 / AUDIT EVIDENCE 199

 

Required

5. Payroll time records

6. Purchase requisitions

7. Receiving reports (documents prepared when merchandise is received) 8. Minutes of the board of directors

9. Remittance advices

10. Signed W-4s (Employee’s Withholding Exemption Certificates) 11. Signed lease agreements

12. Duplicate copies of bills of lading

13. Subsidiary accounts receivable records

14. Cancelled notes payable

15. Duplicate sales invoices

16. Articles of incorporation

17. Title insurance policies for real estate 18. Notes receivable

a. Classify each of the preceding items according to type of documentation: (1) internal or (2) external.

b. Explain why external evidence is more reliable than internal evidence.

7-28 (Objective 7-4) The following are examples of audit procedures:

1. Review the accounts receivable with the credit manager to evaluate their collecti- bility.

2. Compare a duplicate sales invoice with the sales journal for customer name and amount.

3. Add the sales journal entries to determine whether they were correctly totaled.

4. Count inventory items and record the amount in the audit files.

5. Obtain a letter from the client’s attorney addressed to the CPA firm stating that the

Required

7. Obtain a letter from an insurance company to the CPA firm stating the amount of the fire insurance coverage on buildings and equipment.

8. Examine an insurance policy stating the amount of the fire insurance coverage on buildings and equipment.

9. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year.

10. Obtain information about internal control by requesting the client to fill out a questionnaire.

11. Trace the total in the cash disbursements journal to the general ledger.

12. Watch employees count inventory to determine whether company procedures are

being followed.

13. Examine a piece of equipment to make sure that a major acquisition was actually

received and is in operation.

14. Calculate the ratio of sales commission expense to sales as a test of sales commis-

sions.

15. Examine corporate minutes to determine the authorization of the issue of bonds.

16. Obtain a letter from management stating that there are no unrecorded liabilities.

17. Review the total of repairs and maintenance for each month to determine whether

any month’s total was unusually large.

18. Obtain a written statement from a bank stating that the client has $15,671 on deposit

and liabilities of $500,000 on a demand note.

Classify each of the preceding items according to the eight types of audit evidence: (1) physical examination, (2) confirmation, (3) documentation, (4) analytical procedures, (5) inquiries of the client, (6) recalculation, (7) reperformance, and (8) observation.

Part 2 / THE AUDIT PROCESS

attorney is not aware of any existing lawsuits.

6. Extend the cost of inventory times the quantity on an inventory listing to test whether it is accurate.

200

7-29 (Objective 7-4) List two examples of audit evidence the auditor can use in support of each of the following:

a. Recorded amount of entries in the acquisitions journal b. Physical existence of inventory

c. Accuracy of accounts receivable

d. Ownership of fixed assets

e. Liability for accounts payable f . Obsolescence of inventory

g. Existence of petty cash

7-30 (Objective 7-4) Eight different types of evidence were discussed. The following questions concern the reliability of that evidence:

a. Explain why confirmations are normally more reliable evidence than inquiries of the client.

b. Describe a situation in which confirmation will be considered highly reliable and another in which it will not be reliable.

c. Under what circumstances is the physical observation of inventory considered relatively unreliable evidence?

d. Explain why recalculation tests are highly reliable but of relatively limited use.

e. Give three examples of relatively reliable documentation and three examples of less

reliable documentation. What characteristics distinguish the two?

f. Give several examples in which the qualifications of the respondent or the quali-

fications of the auditor affect the reliability of the evidence.

g. Explain why analytical procedures are important evidence even though they are

relatively unreliable by themselves.

7-31 (Objective 7-4) As auditor of the Star Manufacturing Company, you have obtained

Required

a. A trial balance taken from the books of Star one month before year-end:

Cash in bank

Trade accounts receivable

Notes receivable

Inventories

Land

Buildings, net

Furniture, fixtures, and equipment, net Trade accounts payable

Mortgages payable

Capital stock

Retained earnings

Sales

Cost of sales

General and administrative expenses Legal and professional fees

Interest expense

$

Dr. (Cr. )

87,000 345,000 125,000

317,000 66,000 350,000 325,000

(235,000) (400,000) (300,000) (510,000)

(3,130,000 ) 2,300,000 622,000 3,000 35,000

b. There are no inventories consigned either in or out.

c. All notes receivable are due from outsiders and held by Star.

Which accounts should be confirmed with outside sources? Briefly describe from whom they should be confirmed and the information that should be confirmed. Organize your answer in the following format:*

From Whom Information to Be Account Name Confirmed Confirmed

*AICPA adapted.

Required

Chapter 7 / AUDIT EVIDENCE 201

 

Required

a. Identify the type of audit evidence used for each audit procedure.

b. Identify the general transaction-related audit objective or objectives satisfied by each audit procedure.

7-33 (Objective 7-4) The following audit procedures were performed in the audit of inven- tory to satisfy specific balance-related audit objectives as discussed in Chapter 6. The audit procedures assume that the auditor has obtained the inventory count sheets that list the client’s inventory. The general balance-related audit objectives from Chapter 6 are also included.

Audit Procedures

1. Test extend unit prices times quantity on the inventory list, test foot the list, and Acompparge thoe totPalDtoFthe gEenenrahl leadgner.cer

2. Trace selected quantities from the inventory list to the physical inventory to make sure that it exists and the quantities are the same.

3. Question operating personnel about the possibility of obsolete or slow-moving inventory.

4. Select a sample of quantities of inventory in the factory warehouse and trace each item to the inventory count sheets to determine if it has been included and if the quantity

and description are correct.

5. Compare the quantities on hand and unit prices on this year’s inventory count sheets

with those in the preceding year as a test for large differences.

6. Examine sales invoices and contracts with customers to determine whether any goods

are out on consignment with customers. Similarly, examine vendors’ invoices and contracts with vendors to determine whether any goods on the inventory listing are owned by vendors.

7. Send letters directly to third parties who hold the client’s inventory and request that they respond directly to the auditors.

General Balance-Related Audit Objectives

Existence Cutoff

Completeness Detail tie-in

Accuracy Realizable value Classification Rights and obligations

a. Identify the type of audit evidence used for each audit procedure.

b. Identify the general balance-related audit objective or objectives satisfied by each

audit procedure.

7-34 (Objectives 7-3, 7-4) The following are nine situations, each containing two means of accumulating evidence:

1. Confirm receivables with consumers versus confirming accounts receivable with business organizations.

Required

Part 2 / THE AUDIT PROCESS

7-32 (Objective 7-4) The following are various audit procedures performed to satisfy specific transaction-related audit objectives as discussed in Chapter 6. The general transaction-related audit objectives from Chapter 6 are also included.

Audit Procedures

1. Trace from receiving reports to vendors’ invoices and entries in the acquisitions journal.

2. Add the sales journal for the month of July and trace amounts to the general ledger.

3. Examine expense voucher packages and related vendors’ invoices for approval of

expense account classification.

4. Observe opening of cash receipts to determine that cash receipts are promptly

deposited and recorded.

5. Ask the accounts payable clerk about procedures for verifying prices, quantities and

extensions on vendors’ invoices.

6. Vouch entries in sales journal to sales invoices and related shipping documents.

General Transaction-Related Audit Objectives

Occurrence Completeness Accuracy

Posting and summarization Classification

Timing

202

2. Physically examine 3-inch steel plates versus examining electronic parts.

3. Examine duplicate sales invoices when several competent people are checking each other’s work versus examining documents prepared by a competent person on a

one-person staff.

4. Physically examine inventory of parts for the number of units on hand versus

examining them for the likelihood of inventory being obsolete.

5. Discuss the likelihood and amount of loss in a lawsuit against the client with client’s

in-house legal counsel versus discussion with the CPA firm’s own legal counsel.

6. Confirm the oil and gas reserves with a geologist specializing in oil and gas versus

confirming a bank balance.

7. Confirmabankbalanceversusexaminingtheclient’sbankstatements.

8. Physically count the client’s inventory held by an independent party versus con-

firming the count with an independent party.

9. Obtain a physical inventory count from the company president versus physically

counting the client’s inventory.

a. Identify the six factors that determine the reliability of evidence.

b. For each of the nine situations, state whether the first or second type of evidence is more reliable.

c. For each situation, state which of the six factors affected the reliability of the evidence.

7-35 (Objective 7-4) Following are 10 audit procedures with words missing and a list of several terms commonly used in audit procedures.

Audit Procedures

1. _____ the unit selling price times quantity on the duplicate sales invoice and compare the total to the amount on the duplicate sales invoice.

2. _____ whether the accounts receivable bookkeeper is prohibited from handling cash.

Required

3. _____ the ratio of cost of goods sold to sales and compare the ratio to previous years.

4. _____ the sales journal and _____ the total to the general ledger.

determine whether the shipment is a sale or a consignment.

Terms

a. Examine

b. Scan

c. Read

d. Compute

e. Recompute f. Foot

g. Trace

h. Compare

i. Count j. Observe

k. Inquire l. Confirm

5. _____ the sales journal, looking for large and unusual transactions requiring investigation.

6. _____ of management whether all accounting employees are required to take annual vacations.

7. _____ all marketable securities as of the balance sheet date to determine whether they equal the total on the client’s list.

8. _____ the balance in the bank account directly with the East State Bank.

9. _____ a sample of duplicate sales invoices to determine if the controller’s approval is included and _____ each duplicate sales invoice to the sales journal for agreement of

name and amount.

10. _____ the agreement between Johnson Wholesale Company and the client to

a. For each of the 12 blanks in procedures 1 through 10, identify the most appropriate term. No term can be used more than once.

b. For each of the procedures 1 through 10, identify the type of evidence that is being used.

7-36 (Objective 7-4) Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. They range from simple comparisons to the use of complex models involving many relationships and elements of data. They involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditors.

Required

a. Describe the broad purposes of analytical procedures.

Required

Chapter 7 / AUDIT EVIDENCE 203

 

Vandervoort Company

A/C # 110—Notes Receivable

Schedule N-1

Prepared by JD

Approved by PP

TENT CO.

9/3/11 $400/mo. 11/30/11

Date 1-21-12 2-15-12

12-31-11

APEX CO.

6/15/10 6/15/12 None $5,000 5% None

12/31/10 bal.

Additions

Payments (1,000) x

AJAX, INC.

11/21/10 Demand Paid

J.J. CO.

P. SMITH

MARTIN-

PETERSON

Date made

Date due

Paid to date Face amount Interest rate Value of security

Note Receivable:

x

11/1/10 $ 200/mo. 12/31/11 13,180 5% 24,000

12,780

x

py

7/26/11 $1,000/mo. 9/30/11 25,000 5% 50,000

x

5/12/10 Demand Paid $ 2,100 5% None

$ 2,100

x

py

$ $

$

12,000 x 6%

10,000

0 12,000

(1,600) x

$ 3,591 x $ 5%

$ $

$4,000

py

None $ $ 3,591 py $

$(3,591) x

$

0 25,000

(2,400) x (5,000) x (2,100) x

12/31/11 bal. Current

Long-term

Total end. bal.

$3,000

$3,000

$3,000

@

py x

$

$

$

0 $

– $

0 $

0 py $ 102 x

(102) x

10,380

2,400

7,980

10,380

24 577

@

$

$

$

20,000 $ 0

12,000 –

8,000 –

20,000 @$ 0

$ 10,400

$ 4,800

5,600

$ 10,400

TOTALS $22,200 tb

21,580 tb

@ $43,780 tb

Interest Receivable:

12/31/10 bal. $ 104 Interest earned 175 Interest received 0

py $ x

0 468

$ 0 105

$

0

162 x

(108) x

$ 128 1,589 #

(1,116)

x

py x (105) x

(601) x

0 $

(200) x

12/31/11 bal. $ 279 $ 0 $

268 $ 0 $

54 $ 601 a/r

x = Tested

py = Agrees with prior year’s audit schedules. tb = Agrees with working trial balance.

# = Agrees with miscellaneous income analysis in operations w/p. a/r = Agrees with A/R lead schedule.

b. When are analytical procedures required during an audit? Explain why auditors use analytical procedures extensively in all parts of the audit.

c. Describe the factors that influence the extent to which an auditor will use the results of analytical procedures to reduce detailed tests in meeting audit objectives.*

7-37 (Objectives 7-5, 7-6) You are the in-charge on the audit of Vandervoort Company and are to review the audit schedule shown above.

a. List the deficiencies in the audit schedule.

b. For each deficiency, state how the audit schedule could be improved.

c. Prepare an improved audit schedule, using an electronic spreadsheet software program. Include an indication of the audit work done as well as the analysis of the client data (instructor’s option).

CASES

Required

7-38 (Objective 7-4) Grande Stores is a large discount catalog department store chain. The company has recently expanded from 6 to 43 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation

*AICPA adapted.

Part 2 / THE AUDIT PROCESS

204

has disclosed that Grande materially overstated net income. This was accomplished by understating accounts payable and recording fictitious supplier credits that further reduced accounts payable. An SEC investigation was critical of the evidence gathered by Grande’s audit firm, Montgomery & Ross, in testing accounts payable and the supplier credits.

The following is a description of some of the fictitious supplier credits and unrecorded amounts in accounts payable, as well as the audit procedures.

1. McClure Advertising Credits—Grande had arrangements with some vendors to share the cost of advertising the vendor’s product. The arrangements were usually agreed to in advance by the vendor and supported by evidence of the placing of the ad. Grande created a 114-page list of approximately 1,100 vendors, supporting advertising credits of $300,000. Grande’s auditors selected a sample of 4 of the 1,100 items for direct confir- mation. One item was confirmed by telephone, one traced to cash receipts, one to a vendor credit memo for part of the amount and cash receipts for the rest, and one to a vendor credit memo. Two of the amounts confirmed differed from the amount on the list, but the auditors did not seek an explanation for the differences because the amounts were not material.

The rest of the credits were tested by selecting 20 items (one or two from each page of the list). Twelve of the items were supported by examining the ads placed, and eight were supported by Grande debit memos charging the vendors for the promo- tional allowances.

2. Springbrook Credits—Grande created 28 fictitious credit memos totaling $257,000 from Springbrook Distributors, the main supplier of health and beauty aids to Grande. Grande’s controller initially told the auditor that the credits were for returned goods, then said they were a volume discount, and finally stated they were a payment so that Grande would continue to use Springbrook as a supplier. One of the Montgomery & Ross staff auditors concluded that a $257,000 payment to retain Grande’s business was too large to make economic sense.

The credit memos indicated that the credits were for damaged merchandise, volume rebates, and advertising allowances. The audit firm requested a confirmation

of the credits. In response, Jon Steiner, the president of Grande Stores, placed a call to Mort Seagal, the president of Springbrook, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Grande. The Grande officer, posing as Seagal, orally confirmed the credits. Grande refused to allow Montgomery & Ross to obtain written confirmations supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Mark Franklin, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representations of Grande officers.

3. Ridolfi Credits—$130,000 in credits based on 35 credit memoranda from Ridolfi, Inc., were purportedly for the return of overstocked goods from several Grande stores. A Montgomery & Ross staff auditor noted the size of the credit and that the credit memos were dated subsequent to year-end. He further noticed that a sentence on the credit memos from Ridolfi had been obliterated by a felt-tip marker. When held to the light, the accountant could read that the marked-out sentence read, “Do not post until merchandise received.” The staff auditor thereafter called Harold Ridolfi, treasurer of Ridolfi, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Grande by Ridolfi. Steiner advised Franklin, the audit partner, that he had talked to Harold Ridolfi, who claimed he had been misunder- stood by the staff auditor. Steiner told Franklin not to have anyone call Ridolfi to verify the amount because of pending litigation between Grande and Ridolfi, Inc.

4. Accounts Payable Accrual—Montgomery & Ross assigned a senior with experience in the retail area to audit accounts payable. Although Grande had poor internal control, Montgomery & Ross selected a sample of 50 for confirmation of the several thousand vendors who did business with Grande. Twenty-seven responses were received, and 21 were reconciled to Grande’s records. These tests indicated an unrecorded liability of approximately $290,000 when projected to the population of accounts payable. However, the investigation disclosed that Grande’s president made telephone calls to

Chapter 7 / AUDIT EVIDENCE 205

 

Required

Required

some suppliers who had received confirmation requests from Montgomery & Ross and told them how to respond to the request.

Montgomery & Ross also performed a purchases cutoff test by vouching accounts payable invoices received for nine weeks after year-end. The purpose of this test was to identify invoices received after year-end that should have been recorded in accounts payable. Thirty percent of the sample ($160,000) was found to relate to the prior year, indicating a potential unrecorded liability of approximately $500,000. The audit firm and Grande eventually agreed on an adjustment to increase accounts payable by $260,000.

Identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of accounts payable of Grande Stores.

7-39 (Objectives 7-5, 7-6) The long-term debt schedule on page 207 (indexed K-1) was prepared by client personnel and audited by AA, an audit assistant, during the calendar year 2011 audit of American Widgets, Inc., a continuing audit client. The engagement supervisor is reviewing the audit documentation thoroughly.

Identify the deficiencies in the audit schedule that the engagement supervisor should discover.*

ACL PROBLEM

7-40 (Objective 7-4) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material preceding instructions about “Quick Sort” before locating the appropriate command to answer questions a-f. For this problem, use the file labeled “Payroll” in the “Payroll_Analysis” subfolder under tables in Sample_Project. The suggested command or other source of infor- mation needed to solve the problem requirement is included at the end of each question.

a. b.

c. d. e.

f .

 

Determine the number of payroll transactions in the file. (Read the bottom of the Payroll file screen.)

Determine the largest and smallest payroll transaction (gross pay) for the month of September. (Quick Sort)

Determine gross pay for September. (Total)

Determine and print gross pay by department. (Summarize)

Recalculate net pay for each payroll transaction for September and compare it to the amount included in the file. (Filter)

Determine if there are any gaps or duplicates in the check (cheque) numbers. If there are gaps or duplicates, what is your concern? (Gaps and Duplicates)

INTERNET PROBLEM 7-1: USE OF AUDIT SOFTWARE FOR FRAUD DETECTION AND CONTINUOUS AUDITING

Required

The use of audit software has increased dramatically in recent years. Software is now used to fulfill administrative functions in the audit environment, document audit work, and conduct data analysis. This problem requires students to visit the ACL web site (www.acl.com) to learn how auditors use ACL to address issues of fraud detection and continuous auditing.

a. Read about ACL’s solution for fraud detection. What are some of the benefits of ACL for fraud detection?

b. What is continuous monitoring? How might a company use ACL to comply with requirements related to internal control over financial reporting?

Chapter 8

8-1 (Objective 8-1) What are the benefits derived from planning audits? 8-2 (Objective 8-1) Identify the eight major steps in planning audits.

8-3 (Objective 8-2) What are the responsibilities of the successor and predecessor auditors when a company is changing auditors?

8-4 (Objective 8-2) What factors should an auditor consider prior to accepting an engage- ment? Explain.

8-5 (Objective 8-2) What is the purpose of an engagement letter? What subjects should be covered in such a letter?

8-6 (Objective 8-2) Who is considered the client when auditing public companies?

8-7 (Objective 8-2) Which services must be preapproved by the audit committee of a

public company?

8-8 (Objective 8-3) Explain why auditors need an understanding of the client’s industry. What information sources are commonly used by auditors to learn about the client’s industry?

8-9 (Objective 8-3) When a CPA has accepted an engagement from a new client who is a 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.

234

8-10 (Objective 8-3) 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?

8-11 (Objective 8-3) Define what is meant by a related party. What are the auditor’s responsibilities for related parties and related party transactions?

8-12 (Objective 8-3) Which types of loans to executives are permitted by the Sarbanes– Oxley Act?

8-13 (Objective 8-3) In recent years the stock market experienced significant declines, unprecedented since the Great Depression. Why might it be important for you to consider current economic events as part of planning an audit?

8-14 (Objective 8-3) 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.

8-15 (Objective 8-3) 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 impor- tant to read the minutes early in the engagement.

8-16 (Objective 8-3) Identify the three categories of client objectives. Indicate how each objective may affect the auditor’s assessment of inherent risk and need for evidence accumulation.

8-17 (Objective 8-3) What is the purpose of the client’s performance measurement system? How might that system be useful to the auditor? Give examples of key performance indicators for the following businesses: (1) a chain of retail clothing stores; (2) an Internet portal; (3) a hotel chain.

8-18 (Objective 8-4) Define client business risk and describe several sources of client business risk. What is the auditor’s primary concern when evaluating client business risk?

8-19 (Objective 8-4) Describe top management controls and their relation to client busi- ness risk. Give examples of effective management and governance controls.

8-20 (Objectives 8-5, 8-6) What are the purposes of preliminary analytical procedures? What types of comparisons are useful when performing preliminary analytical procedures?

8-21 (Objective 8-6) When are analytical procedures required on an audit? What is the primary purpose of analytical procedures during the completion phase of the audit?

8-22 (Objective 8-7) Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For several engagements, he computed the industry ratios included in publications by Standard and Poor’s 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 automatically explained 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 can Gordon improve the quality of his analytical procedures?

8-23 (Objective 8-7) 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 makes 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.

8-24 (Objective 8-8) 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?

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 235

 

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

8-25 (Objectives 8-1, 8-3) The following questions concern the planning of the engage- ment. Select the best response.

a. Which of the following is an effective audit planning procedure that helps prevent misunderstandings and inefficient use of audit personnel?

(1) Arrange to make copies, for inclusion in the audit files, of those client supporting

documents examined by the auditor.

(2) Arrangetoprovidetheclientwithcopiesoftheauditprogramstobeusedduring

the audit.

(3) Arrange a preliminary conference with the client to discuss audit objectives, fees,

timing, and other information.

(4) Arrange to have the auditor prepare and post any necessary adjusting or reclassi-

fication entries prior to final closing.

b. When auditing related party transactions, an auditor places primary emphasis on (1) confirming the existence of the related parties.

(2) verifying the valuation of related party transactions.

(3) evaluating the disclosure of the related party transactions.

(4) ascertaining the rights and obligations of the related parties.

c. Which of the following will most likely indicate the existence of related parties? (1) Writing down obsolete inventory prior to year end.

(2) Failing to correct deficiencies in the client’s internal control.

(3) An unexplained increase in gross margin.

(4) Borrowing money at a rate significantly below the market rate.

d. Which of the following is least likely to be included in the auditor’s engagement letter?

(1) Details about the preliminary audit strategy.

(2) Overview of the objectives of the engagement.

(3) Statement that management is responsible for the financial statements. (4) Description of the level of assurance obtained when conducting the audit.

8-26 (Objective 8-2) The following questions pertain to client acceptance. Choose the best response.

a. In assessing whether to accept a client for an audit engagement, a CPA should consider

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

Client Business Risk

Yes Yes No No

Acceptable Audit Risk

Yes No Yes No

Part 2 / THE AUDIT PROCESS

b. When approached to perform an audit for the first time, the CPA should make inquiries of the predecessor auditor. This is a necessary procedure because the predecessor may be able to provide the successor with information that will assist the successor in determining whether

(1) the predecessor’s work should be used.

(2) the company follows the policy of rotating its auditors.

(3) inthepredecessor’sopinioninternalcontrolofthecompanyhasbeensatisfactory. (4) the engagement should be accepted.

c. A successor would most likely make specific inquiries of the predecessor auditor regarding (1) specialized accounting principles of the client’s industry.

(2) the competency of the client’s internal audit staff.

(3) the uncertainty inherent in applying sampling procedures.

(4) disagreements with management as to auditing procedures.

236

8-27 (Objectives 8-5, 8-6, 8-7, 8-8) The following questions concern the use of analytical procedures during an audit. Select the best response.

a. Analytical procedures used in planning an audit should focus on identifying (1) material weaknesses in internal control.

(2) the predictability of financial data from individual transactions.

(3) the various assertions that are embodied in the financial statements.

(4) areas that may represent specific risks relevant to the audit.

b. For all audits of financial statements made in accordance with auditing standards, the use of analytical procedures is required to some extent

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

In the

Planning Stage

Yes No No Yes

As a

Substantive Test

No Yes Yes No

In the

Completion Stage

Yes No Yes No

c. Which of the following is least likely to be comparable between similar corporations in the same industry line of business?

(1) Accounts receivable turnover

(2) Earnings per share

(3) Gross profit percent

(4) Return on assets before interest and taxes

d. Which of the following situations has the best chance of being detected when a CPA compares 2011 revenues and expenses with the prior year and investigates all changes exceeding a fixed percent?

(1) An increase in property tax rates has not been recognized in the company’s 2011

accrual.

(2) The cashier began lapping accounts receivable in 2011.

(3) Because of worsening economic conditions, the 2011 provision for uncollectible accounts was inadequate.

(4) The company changed its capitalization policy for small tools in 2011.

DISCUSSION QUESTIONS AND PROBLEMS

8-28 (Objectives 8-2, 8-3, 8-4, 8-5) The following are various activities an auditor does during audit planning.

1. Send an engagement letter to the client.

2. Tour the client’s plant and offices.

3. Compare key ratios for the company to industry competitors.

4. Review management’s risk management controls and procedures. 5. Review accounting principles unique to the client’s industry.

6. Determine the likely users of the financial statements.

7. Identify potential related parties that may require disclosure.

8. Identify whether any specialists are required for the engagement.

For each procedure, indicate which of the first four parts of audit planning the procedure primarily relates to: (1) accept client and perform initial audit planning; (2) understand the client’s business and industry; (3) assess client business risk; (4) perform preliminary analytical procedures.

8-29 (Objective 8-3) In your audit of Canyon Outdoor Provision Company’s financial statements, the following transactions came to your attention:

1. Canyon Outdoor’s operating lease for its main store is with York Properties, which is a real estate investment firm owned by Travis Smedes. Mr. Smedes is a member of Canyon Outdoor’s board of directors.

Required

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 237

 

Required

2. One of Canyon Outdoor’s main suppliers for kayaks is Hessel Boating Company. Canyon Outdoor has purchased kayaks and canoes from Hessel for the last 25 years, under a long-term contract arrangement.

3. Short-term financing lines of credit are provided by Cameron Bank and Trust. Suzanne Strayhorn is the lending officer assigned to the Canyon Outdoor account. Suzanne is the wife of the largest investor of Canyon Outdoor.

4. Hillsborough Travel partners with Canyon Outdoor to provide hiking and rafting adventure vacations. The owner of Hillsborough Travel lives in the same neighbor- hood as the CEO of Canyon Outdoor. They are acquaintances, but not close friends.

5. The board of directors consists of several individuals who own stock in Canyon Outdoor. At a recent board meeting, the board approved its annual dividend payable to shareholders effective June 1.

a. Define what constitutes a “related party.”

b. Which of the preceding transactions would most likely be considered to be a related party transaction?

c. What financial statement implications, if any, would each of the above transactions have for Canyon Outdoor?

d. What procedures might auditors consider to help them identify potential related party transactions for clients like Canyon Outdoor?

8-30 (Objective 8-3) The minutes of the board of directors of the Tetonic Metals Company for the year ended December 31, 2011, were provided to you.

Meeting of March 5, 2011

The meeting of the board of directors of Tetonic Metals was called to order by the James Cook, chairman of the board, at 8:30 am. The following directors were in attendance:

Part 2 / THE AUDIT PROCESS

Irene Arnold James Cook Brian McDonald Robert Beardsley Larry Holden Tony Williams

Mary Beth Cape Heather Jackson

The board approved the minutes from the November 22, 2010 meeting.

The board reviewed the financial statements for the most recent fiscal year that ended December 31, 2010. Due to strong operating results, the board declared an increase in the annual dividend to common shareholders from $.32 to $.36 per

common share payable on May 10, 2011 to shareholders of record on April 25, 2011. Tony Williams, CEO, led a discussion of the seven core strategic initiatives in the 2011-2013 strategic plan. The most immediate initiative is the expansion of Tetonic operations into the Pacific Northwest. The board approved an increased budget for 2011

administrative expenses of $1 million to open offices in the Portland, Oregon area. Mr. Williams also led a discussion of a proposed acquisition of one of Tetonic’s smaller competitors. The board discussed synergies that might be possible if the operations of the acquired company could be successfully integrated with the operations of Tetonic. The board granted Williams and the management team

approval to continue negotiations with the other company’s board and management. The board continued its discussion from prior meetings about the October 2010 report from the Environmental Protection Agency (EPA) regarding dust impact at Tetonic’s zinc refineries. Legal counsel for Tetonic updated the board on the status of negotiations with the EPA regarding findings contained in the report. The board asked management to include an update on the status of any resolutions for its next meeting. The board also asked management to schedule a conference call, if necessary,

for the board if issues need to be resolved before the next meeting.

Officer bonuses for the year ended December 31, 2010 were approved for payment

on April 14, 2011, as follows:

Tony Williams—Chief Executive Officer

Mary Beth Cape—Chief Operating Officer Bob Browning—Chief Financial Officer

$275,000 $150,000 $125,000

238

The Audit Committee and the Compensation Committee provided an update of issues discussed at each of their respective meetings.

The meeting adjourned 5:30 pm.

Meeting of October 21, 2011

The meeting of the board of directors of Tetonic Metals was called to order by the James Cook, chairman of the board, at 8:30 am. The following directors were in attendance:

Irene Arnold Robert Beardsley Mary Beth Cape

James Cook Brian McDonald Larry Holden Tony Williams Heather Jackson

The board approved the minutes from the March 5, 2011 meeting.

Tony Williams, CEO, provided an overview of financial performance and operating results for the nine months ended September 30, 2011. Given the volatility in the economy, Tetonic sales have fallen by over 8% compared to the same period in 2010. To address the drop in revenues, Tetonic has scaled back mining operations by a similar percentage to reduce labor and shipping costs.

Bob Browning, CFO, updated the board on discussions with banks that will be financing the acquisition of the Tetonic competitor. The terms of the $7 million financing include a floating interest rate that is 2% above prime over the ten year life of the loan. Payments will be made quarterly and Tetonic will have to maintain com- pliance with certain loan covenant restrictions that are tied to financial performance. The board approved the acquisition and related loan transaction and scheduled a closing date for the financing to be November 1, 2011.

To prepare for the proposed acquisition, the board approved an increase in the

capital expenditures budget of $1.5 million to cover costs of expanding computer

operations, including a new server. The new equipment is needed to successfully

integrate IT operations at Tetonic and the acquired company. The equipment will be

installed in December 2011. Existing equipment that was purchased in 2009 will no

longer be used in the IT operations at Tetonic.

The board discussed the creation of an incentive stock option plan for senior

executives as a way to better align management and shareholder incentives. Consultants from a compensation advisory firm and tax attorneys from a national accounting firm led a discussion of the components of the proposed plan, including discussion of the related tax implications. The board asked the consultants to revise the plan based on comments received at the meeting for presentation at the board’s next meeting.

Tetonic’s external auditor provided an update of its interim work related to tests of the operating effectiveness of internal controls over financial reporting. The audit partner presented a written report that provided information about three deficiencies in internal control considered to be significant by the auditor.

Legal counsel for Tetonic updated the board on final resolution of the EPA report findings. The final settlement requires Tetonic to modify some of the air handling equipment at its zinc refineries that are expected to cost about $400,000. No other penalties were imposed by the EPA.

The Audit Committee and the Compensation Committee provided an update of issues discussed at each of their respective meetings.

a. How do you, as the auditor, know that all minutes have been made available to you? Required

b. Read the minutes of the meetings of March 5 and October 21. Use the following format to list and explain information that is relevant for the 2011 audit:

Information Relevant to 2011 Audit Audit Action Required

1. 2.

c. Read the minutes of the meeting of March 5, 2011. Did any of that information pertain to the December 31, 2010, audit? Explain what the auditor should have done during the December 31, 2010, audit with respect to 2011 minutes.

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 239

 

Required

8-31 (Objective 8-6) Analytical procedures are an important part of the audit process and consist of the evaluation of financial information by the study of plausible relationships among financial and nonfinancial data. Analytical procedures may be done during planning, as a substantive test, or as a part of the overall review of an audit.

The following are various statements regarding the use of analytical procedures:

1. Not required during this stage.

2. Should focus on enhancing the auditor’s understanding of the client’s business and

the transactions and events that have occurred since the last audit date.

3. Should focus on identifying areas that may represent specific risks relevant to the audit.

4. Require documentation in the working papers of the auditor’s expectation of the ratio

or account balance.

5. Do not result in detection of misstatements.

6. Designed to obtain evidential matter about particular assertions related to account

balances or classes of transactions.

7. Generally use data aggregated at a lower level than the other stages.

8. Should include reading the financial statements and notes to consider the adequacy

of evidence gathered.

9. Involve reconciliation of confirmation replies with recorded book amounts.

10. Use the preliminary or unadjusted working trial balance as a source of data.

11. Expected to result in a reduced level of detection risk.

For each of the 11 statements, select the stage of the audit for which the statement is most accurate using the following responses:

1. Planning the audit

2. Substantive testing

3. Overall review

4. Statement is not correct concerning analytical procedures.*

8-32 (Objectives 8-5, 8-7, 8-8) You are auditing payroll for the Morehead Technologies company for the year ended October 31, 2011. Included next are amounts from the client’s

trial balance, along with comparative audited information for the prior year.

Sales

Executive salaries

Factory hourly payroll Factory supervisors’ salaries Office salaries

Sales commissions

Audited Balance

10/31/2010

$ 51,316,234 546,940 10,038,877 785,825 1,990,296 2,018,149

Preliminary Balance

10/31/2011

$ 57,474,182 615,970 11,476,319 810,588 2,055,302 2,367,962

Part 2 / THE AUDIT PROCESS

You have obtained the following information to help you perform preliminary analytical procedures for the payroll account balances.

1. There has been a significant increase in the demand for Morehead’s products. The increase in sales was due to both an increase in the average selling price of 4 percent and an increase in units sold that resulted from the increased demand and an increased marketing effort.

2. Even though sales volume increased there was no addition of executives, factory supervisors, or office personnel.

3. All employees including executives, but excluding commission salespeople, received a 3 percent salary increase starting November 1, 2010. Commission salespeople receive their increased compensation through the increase in sales.

4. The increased number of factory hourly employees was accomplished by recalling employees that had been laid off. They receive the same wage rate as existing employees. Morehead does not permit overtime.

5. Commission salespeople receive a 5 percent commission on all sales on which a commission is given. Approximately 75 percent of sales earn sales commission. The

*AICPA adapted.

240

other 25 percent are “call-ins”, for which no commission is given. Commissions are paid in the month following the month they are earned.

a. Use the final balances for the prior year included on the preceding page and the infor- mation in items 1 through 5 to develop an expected value for each account, except sales.

b. Calculate the difference between your expectation and the client’s recorded amount as a percentage using the formula (expected value-recorded amount)/expected value.

8-33 (Objectives 8-3, 8-7, 8-8) Your comparison of the gross margin percent for Jones Drugs for the years 2008 through 2011 indicates a significant decline. This is shown by the following information:

Required

2011

$ 14,211

9,223 _______

Gross margin

Percent 35.1

2010

$ 12,916

8,266 _______

$ 4,650 36.0

2009

$ 11,462

7,313 _______

$ 4,149 36.2

2008

$ 10,351

6,573 _______

$ 3,778 36.5

Sales (thousands) CGS (thousands)

$ 4,988

A discussion with Marilyn Adams, the controller, brings to light two possible explana- tions. She informs you that the industry gross profit percent in the retail drug industry declined fairly steadily for 3 years, which accounts for part of the decline. A second factor was the declining percent of the total volume resulting from the pharmacy part of the business. The pharmacy sales represent the most profitable portion of the business, yet the competition from discount drugstores prevents it from expanding as fast as the nondrug items such as magazines, candy, and many other items sold. Adams feels strongly that these two factors are the cause of the decline.

The following additional information is obtained from independent sources and the client’s records as a means of investigating the controller’s explanations:

Jones Drugs ($ in thousands)

Industry Gross

2011 2010 2009 2008

Drug Sales

$5,126 5,051 4,821 4,619

Nondrug Sales Goods Sold

$9,085 $3,045 7,865 2,919 6,641 2,791 5,732 2,665

Goods Sold

$6,178 5,347 4,522 3,908

and Related Products

32.7 32.9 33.0 33.2

_________________________________________________________ Profit Percent for

Drug Cost of Nondrug Cost of Retailers of Drugs

a. Evaluate the explanation provided by Adams. Show calculations to support your conclusions.

b. Which specific aspects of the client’s financial statements require intensive investi- gation in this audit?

8-34 (Objectives 8-7, 8-8) In the audit of the Worldwide Wholesale Company, you did extensive ratio and trend analysis. No material exceptions were discovered except for the following:

1. Commission expense as a percent of sales has stayed constant for several years but has increased significantly in the current year. Commission rates have not changed.

2. The rate of inventory turnover has steadily decreased for 4 years.

3. Inventory as a percent of current assets has steadily increased for 4 years.

4. The number of days’ sales in accounts receivable has steadily increased for 3 years.

5. Allowance for uncollectible accounts as a percent of accounts receivable has steadily

decreased for 3 years.

6. The absolute amounts of depreciation expense and depreciation expense as a

percent of gross fixed assets are significantly smaller than in the preceding year.

a. Evaluate the potential significance of each of the exceptions just listed for the fair presentation of financial statements.

b. State the follow-up procedures you would use to determine the possibility of material misstatements.

Required

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 241

Required

 

8-35 (Objectives 8-3, 8-5) As part of the analytical procedures of Mahogany Products, Inc., you perform calculations of the following ratios:

Ratio 2011 2010 2011 2010

Industry Mahogany Averages Products

________________

________________

1. Current ratio

2. Days to collect receivables

3. Days to sell inventory

4. Purchases divided by accounts payable

5. Inventory divided by current assets

6. Operating income divided by tangible assets

7. Operating income divided by net sales

8. Gross profit percent

9. Earnings per share

For each of the preceding ratios:

3.30 3.80 87.00 93.00 126.00 121.00 11.70 11.60 .56 .51 .08 .06 .06 .06 .21 .27 $14.27 $13.91

2.20 2.60 67.00 60.00 93.00 89.00 8.50 8.60 .49 .48 .14 .12 .04 .04 .21 .19 $2.09 $1.93

Required

a. State whether there is a need to investigate the results further and, if so, the reason for further investigation.

b. State the approach you would use in the investigation.

c. Explain how the operations of Mahogany Products appear to differ from those of the industry.

8-36 (Objectives 8-3, 8-5, 8-7) Following are the auditor’s calculations of several key ratios for Cragston Star Products. The primary purpose of this information is to understand the client’s business and assess the risk of financial failure, but any other relevant conclusions are also desirable.

Ratio 2011 2010 2009 2008 2007

1. Current ratio 2.08 2.26 2.51 2.43 2.50

Required

a. What major conclusions can be drawn from this information about the company’s future?

b. What additional information would be helpful in your assessment of this company’s financial condition?

c. Based on the preceding ratios, which aspects of the company do you believe should receive special emphasis in the audit?

8-37 (Objectives 8-3, 8-4) The Internet has dramatically increased global e-commerce activities. Both traditional “brick and mortar” businesses and new dot-com businesses use the Internet to meet business objectives. For example, eBay successfully offers online auctions as well as goods for sale in a fixed price format.

a. Identify business strategies that explain eBay’s decision to offer goods for sale at fixed prices.

b. Describe three business risks related to eBay’s operations.

c. Acquisitions by eBay in recent years include PayPal, an online payment service, and Skype, an internet communications company. Discuss possible reasons why eBay made these strategic acquisitions.

Required

Part 2 / THE AUDIT PROCESS

1.34 1.82 1.76 1.64

4.10 5.30 7.10

4.10 5.40 5.60 89.02 67.59 65.18 2.68 3.34 3.36 136.19 109.28 108.63 .73 .69 .67 .16 .15 .14 .12 .10 .09 .10 .10 .11 $4.49 $4.26 $4.14

2. Quick ratio .97

3. Times interest earned

4. Accounts receivable turnover

5. Days to collect receivables

6. Inventory turnover

7. Daystosellinventory

8. Net sales divided by tangible assets

9. Profit margin

3.50

10. Returnonassets 11. Returnonequity 12. Earningspershare

3.20 4.20 5.50 86.90 66.36 2.03 1.84 179.80 198.37 .68 .64 .13 .14 .09 .09 .05 .06 $4.30 $4.26

242

d. Four years after acquiring Skype, eBay sold most of its interest in the company. Discuss how that impacts eBay’s business risks.

e. Identify possible risks that can lead to material misstatements in the eBay financial statements if business risks related to its operations, including recent acquisitions and divestitures, are not effectively managed.

CASES

8-38 (Objectives 8-2, 8-3, 8-4) Winston Black was an audit partner in the firm of Henson, Davis & Company. He was in the process of reviewing the audit files for the audit of a new client, McMullan Resources. McMullan was in the business of heavy construction. Black was conducting his first review after the audit was substantially complete. Normally, he would have done an initial review during the planning phase as required by his firm’s policies; however, he had been overwhelmed by an emergency with his largest and most important client. He rationalized not reviewing audit planning information because (1) the audit was being overseen by Sarah Beale, a manager in whom he had confidence, and (2) he could “recover” from any problems during his end-of-audit review.

Now, Black found that he was confronted with a couple of problems. First, he found that the firm may have accepted McMullan without complying with its new-client acceptance procedures. McMullan came to Henson, Davis & Company on a recommendation from a friend of Black’s. Black got “credit” for the new business, which was important to him because it would affect his compensation from the firm. Because Black was busy, he told Beale to conduct a new-client acceptance review and let him know if there were any problems. He never heard from Beale and assumed everything was okay. In reviewing Beale’s preaudit planning documentation, he saw a check mark in the box “Contact prior auditors” but found no details indicating what was done. When he asked Beale about this, she responded with the following:

The tax contingency issue that Beale referred to was a situation in which McMullan had entered into litigation with a bank from which it had received a loan. The result of the litigation was that the bank forgave several hundred thousand dollars in debt. This was a windfall to McMullan, and they recorded it as a gain, taking the position that it was non- taxable. The prior auditors disputed this position and insisted that a contingent tax liability existed that required disclosure. This upset McMullan, but the company agreed in order to receive an unqualified opinion. Before hiring Henson, Davis & Company as their new auditors, McMullan requested that the firm review the situation. Henson, Davis & Company believed the contingency was remote and agreed to the elimination of the disclosure.

The second problem involved a long-term contract with a customer in Montreal. Under accounting standards, McMullan was required to recognize income on this contract using the percentage-of-completion method. The contract was partially completed as of year-end and had a material effect on the financial statements. When Black went to review the copy of the contract in the audit files, he found three things. First, there was a contract summary that set out its major features. Second, there was a copy of the contract written in French. Third, there was a signed confirmation confirming the terms and status of the contract. The space request- ing information about any contract disputes was left blank, indicating no such problems.

Black’s concern about the contract was that to recognize income in accordance with accounting standards, the contract had to be enforceable. Often, contracts contain a can- cellation clause that might mitigate enforceability. Because he was not able to read French,

“I called Gardner Smith [the responsible partner with McMullan’s prior audit firm] and left a voicemail message for him. He never returned my call. I talked to Ted McMullan about the change, and he told me that he informed Gardner about the change and that Gardner said, “Fine, I’ll help in any way I can.” Ted said Gardner sent over copies of analyses of fixed assets and equity accounts, which Ted gave to me. I asked Ted why they replaced Gardner’s firm, and he told me it was over the tax contingency issue and the size of their fee. Other than that, Ted said the relationship was fine.”

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 243

 

Required

Black couldn’t tell whether the contract contained such a clause. When he asked Beale about this, she responded that she had asked the company’s vice president for the Canadian division about the contract and he told her that it was their standard contract. The company’s standard contract did have a cancellation clause in it, but it required mutual agreement and could not be cancelled unilaterally by the buyer.

a. Evaluate and discuss whether Henson, Davis & Company complied with auditing standards in their acceptance of McMullan Resources as a new client. What can they do at this point in the engagement to resolve deficiencies if they exist?

b. Evaluate and discuss whether sufficient audit work has been done with regard to McMullan’s Montreal contract. If not, what more should be done?

c. Evaluate and discuss whether Black and Beale conducted themselves in accordance with auditing standards.

8-39 (Objectives 8-3, 8-4, 8-7) Solomon is a highly successful, closely held Boston, Massachusetts, company that manufactures and assembles automobile specialty parts that are sold in auto parts stores in the East. Sales and profits have expanded rapidly in the past few years, and the prospects for future years are every bit as encouraging. In fact, the Solomon brothers are currently considering either selling out to a large company or going public to obtain additional capital.

The company originated in 1984 when Frank Solomon decided to manufacture tooled parts. In 1999, the company changed over to the auto parts business. Fortunately, it has never been necessary to expand the facilities, but space problems have recently become severe and expanded facilities will be necessary. Land and building costs in Boston are currently extremely inflated.

Management has always relied on you for help in its problems because the treasurer is sales-oriented and has little background in the controllership function. Salaries of all officers have been fairly modest in order to reinvest earnings in future growth. In fact, the company is oriented toward long-run wealth of the brothers more than toward short-run profit. The brothers have all of their personal wealth invested in the firm.

Required

A major reason for the success of Solomon has been the small but excellent sales force. The sales policy is to sell to small auto shops at high prices. This policy is responsible for fairly high credit losses, but the profit margin is high and the results have been highly successful. The firm has every intention of continuing this policy in the future.

Your firm has been auditing Solomon since 1994, and you have been on the job for the past 3 years. The client has excellent internal controls and has always been cooperative. In recent years, the client has attempted to keep net income at a high level because of borrowing needs and future sellout possibilities. Overall, the client has always been pleasant to deal with and willing to help in any way possible. There have never been any major audit adjustments, and an unqualified opinion has always been issued.

In the current year, you have completed the tests of the sales and collection area. The tests of controls and substantive tests of transactions for sales and sales returns and allow- ances were excellent, and extensive confirmations yielded no material misstatements. You have carefully reviewed the cutoff for sales and for sales returns and allowances and find these to be excellent. All recorded bad debts appear reasonable, and a review of the aged trial balance indicates that conditions seem about the same as in past years.

a. Evaluate the information in the case (see below) to provide assistance to management for improved operation of its business. Prepare the supporting analysis using an electronic spreadsheet program (instructor option).

b. Do you agree that sales, accounts receivable, and allowance for doubtful accounts are probably correctly stated? Show calculations to support your conclusion.

Balance Sheet

Cash

Accounts receivable

12-31-11

(Current Year)

$ 49,615 2,366,938

12-31-10

$ 39,453 2,094,052

12-31-09 12-31-08

$ 51,811 $ 48,291 1,756,321 1,351,470

Part 2 / THE AUDIT PROCESS

244

Balance Sheet (continued)

12-31-11

(Current Year)

12-31-10

12-31-09

12-31-08

Allowance for doubtful accounts (250,000) Inventory 2,771,833

(240,000) 2,585,820 4,479,325 3,744,590

$8,223,915

$2,286,433 4,525,310 1,412,172

$8,223,915

$6,165,411 (186,354) (63,655) (245,625)

$5,669,777 $1,360,911 $ 322,250

$ 881,232 697,308 368,929 146,583 $2,094,052

(220,000) 2,146,389 3,734,521 3,498,930

$7,233,451

$1,951,830 4,191,699 1,089,922

$7,233,451

$5,313,752 (158,367) (52,183) (216,151)

$4,887,051 $1,230,640 $ 283,361

$ 808,569 561,429 280,962 105,361 $1,756,321

(200,000) 1,650,959 2,850,720 3,132,133

$5,982,853

$1,625,811 3,550,481 806,561 $5,982,853

$4,251,837 (121,821) (42,451) (196,521)

$3,891,044 $1,062,543 $ 257,829

$ 674,014 407,271 202,634 67,551 $1,351,470

Current assets Fixed assets Total assets

Current liabilities

Long-term liabilities

Owners’ equity

Total liabilities and owners’ equity

Income Statement Information

Sales

Sales returns and allowances Sales discounts allowed

Bad debts

Net sales

Gross margin

Net income after taxes

Aged Accounts Receivable

0 – 30 days

31 – 60 days

61 – 120 days

>120 days

Total $2,366,938

8-40 (Objectives 8-3, 8-4, 8-5)

Introduction

4,938,386

3,760,531 $8,698,917

$2,253,422 4,711,073 1,734,422

$8,698,917

$6,740,652 (207,831) (74,147) (248,839)

$6,209,835 $1,415,926 $ 335,166

$ 942,086 792,742 452,258 179,852

 

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART I

This case study is presented in seven parts. Each part deals largely with the material in the chapter to which that part relates. However, the parts are connected in such a way that in completing all seven, you will gain a better understanding of how the parts of the audit are interrelated and integrated by the audit process. The parts of this case appear in the following textbook chapters:

• Part I—Perform analytical procedures for different phases of the audit, Chapter 8.

• Part II—Understand factors influencing risks and the relationship of risks to audit

evidence, Chapter 9.

• Part III—Understand internal control and assess control risk for the acquisition and

payment cycle, Chapter 10.

• Part IV—Conduct fraud brainstorming and assess fraud risks, Chapter 11.

• Part V—Design tests of controls and substantive tests of transactions, Chapter 14.

• Part VI—Determine sample sizes using audit sampling and evaluate results, Chapter 15.

• Part VII—Design, perform, and evaluate results for tests of details of balances,

Chapter 16. Background Information

Your audit firm has recently been engaged as the new auditor for Pinnacle Manufacturing effective for the audit of the financial statements for the year ended December 31, 2011. Pinnacle is a medium-sized corporation, with its headquarters located in Detroit,

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 245

 

Michigan. The company is made up of three divisions. The first division, Welburn, has been in existence for 35 years and creates powerful diesel engines for boats, trucks, and commercial farming equipment. The second division, Solar-Electro, was recently acquired from a high-tech manufacturing firm based out of Dallas, Texas. Solar-Electro produces state-of-the-art, solar-powered engines. The solar-powered engine market is relatively new, and Pinnacle’s top management believes that the Solar-Electro division will be extremely profitable in the future as the focus on global climate change continues and when highly anticipated EPA regulations make solar-powered engines mandatory for certain public transportation vehicles. Finally, the third division, Machine-Tech, engages in a wide variety of machine service and repair operations. This division, also new to Pinnacle, is currently in its second year of operations. Pinnacle’s board of directors has recently considered selling the Machine-Tech division in order to focus more on core operations—engine manufacturing. However, before any sale will be made, the board has agreed to evaluate this year’s operating results. Excellent operating results may have the effect of keeping the division a part of Pinnacle for the next few years. The vice president for Machine-Tech is committed to making it profitable.

PART I

Required

The purpose of Part I is to perform preliminary analytical procedures as part of the audit planning process. You have been asked to focus your attention on two purposes of analyti- cal procedures: obtain an understanding about the client’s business and indicate where there is an increased likelihood of misstatements.

a. Refer to the financial statement data in Figure 8-9 for the current year and prior two years. Analyze the year-to-year change in account balance for at least five financial statement line items. Document the trend analysis in a format similar to the following:

Account Balance 2010–2011 2009–2010

% Change % Change

Net sales

b. Calculate at least five common ratios shown on pages 232–233 and document them in a format similar to the following:

Ratio 2011 2010 2009

Current ratio

c. Based on the analytical procedures calculated in parts a. and b., summarize your observations about Pinnacle’s business, including your assessment of the client’s business risk.

d. Go to the Pinnacle link on the textbook Web site (www.prenhall.com/arens) and open the Pinnacle income statement, which is located in the Pinnacle Income Statement worksheet of the Pinnacle_Financials Excel file. Use the income statement infor- mation to prepare a common-size income statement for all three years. See Figure 8-7 (p. 229) for an example. Use the information to identify accounts for which you believe there is a concern about material misstatements. Use a format similar to the following:

Estimate of $ Amount Account Balance of Potential Misstatement

e. Use the three divisional income statements in the Pinnacle_Financials Excel file on the Web site to prepare a common-size income statement for each of the three divisions for all three years. Each division’s income statement is in a separate worksheet in the Excel file. Use the information to identify accounts for which you believe there is a concern about material misstatements. Use a format similar to the one in requirement d.

f . Explain whether you believe the information in requirement d or e provides the most useful data for evaluating the potential for misstatements. Explain why.

Part 2 / THE AUDIT PROCESS

246

FIGURE 8-9

Pinnacle Manufacturing Financial Statements

Pinnacle Manufacturing Company Income Statement

For the Year ended December 31

Net sales

Cost of goods sold

Gross profit Operating expenses

Income from operations Other revenues and gains Other expenses and losses Income before income tax

Income tax

Net income for the year Earnings per share

2011

$ 150,737,628 109,284,780 41,452,848 37,177,738 4,275,110

— 2,181,948 2,093,162

883,437 1,209,725 $1.21

2010

$ 148,586,037 106,255,499 42,330,538 38,133,969 4,196,569

— 2,299,217 1,897,352

858,941 1,038,411 $1.04

2009

$ 144,686,413 101,988,165 42,698,248 37,241,108 5,457,140

— 2,397,953 3,059,187 1,341,536 1,717,651

$1.72

Assets Current assets

$ 7,721,279 13,042,165 Inventory 32,236,021 Other current assets 172,278 Total current assets 53,171,743 Property, plant and equipment 62,263,047 $ 115,434,790

Pinnacle Manufacturing Company Balance Sheet

As of December 31

2011

2010

7,324,846

2009

8,066,545

7,936,409 25,271,503 131,742 41,406,199 58,268,732 99,674,931

Cash and cash equivalents Net receivables

$

$

$

Total assets

8,619,857 25,537,198 143,206 41,625,107 61,635,530 $ 103,260,637

Liabilities Current liabilities

Accounts payable Short/current long-term debt Other current liabilities

Total current liabilities Long-term debt

Total liabilities

Stockholders’ equity Common stock Additional paid-in capital Retained earnings

Total stockholders’ equity

Total liabilities & stockholders’ equity

$ 12,969,686 15,375,819 2,067,643 30,413,148 24,420,090 54,833,238

1,000,000 15,717,645 43,883,907 60,601,552

$ 115,434,790

$

9,460,776 10,298,668 1,767,360 21,526,804 22,342,006 43,868,810

1,000,000 15,717,645 42,674,182 59,391,827

$

7,586,374 9,672,670 1,682,551

18,941,595 22,379,920 41,321,515

1,000,000 15,717,645 41,635,771 58,353,416

$ 103,260,637

$ 99,674,931

g. Analyze the account balances for accounts receivable, inventory, and short/current long-term debt. Describe any observations about those accounts and discuss additional information you want to consider during the current year audit.

h. Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacle is likely to fail financially in the next 12 months.

ACL PROBLEM

8-41 (Objectives 8-5 and 8-7) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the

Chapter 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 247

 

Required

reference material preceding instructions about “Quick Sort” before locating the appro- priate command to answer questions a-c. For this problem use the “Inventory” file in the “Inventory_Review” subfolder under tables in Sample_Project. The suggested command or other source of information needed to solve the problem requirement is included at the end of each question.

a. Obtain and print statistical information for both Inventory Value at Cost and Market Value. Determine how many inventory items have positive, negative, and zero values for both Inventory Value at Cost and Market Values. (Statistics)

b. Use Quick Sort Ascending and Descending for both Inventory Value at Cost and Market Value. (Quick Sort) Use this information and the information from part a to identify any concerns you have in the audit of inventory.

c. Calculate the ratio of Inventory Value at Cost to Market Value and sort the result from low to high. (Computed Fields and Quick Sort) Identify concerns about inventory valuation, if any.

INTERNET PROBLEM 8-1:

OBTAIN CLIENT BACKGROUND INFORMATION

Required

intended for current and future investors, they also provide rich information for auditors, especially during the client acceptance and continuance phase of an audit. Additionally, similar disclosures by a client’s competitors in their financial statements may also provide useful industry specific information that can be helpful during audit planning.

a. Visit the SEC’s website (www.sec.gov) and locate the most recent Form 10-K filing for The Coca-Cola Company (search for “Coca Cola Co”).

b. Review the information contained in Items 1, 1A, and 7 in the Form 10-K. Describe the nature of information included in each of these sections of the Form 10-K and discuss how the information might be helpful to auditors in obtaining an under- standing of the client’s business and industry.

c. Locate the most recent Form 10-K filing for PepsiCo, Inc. (search for “PepsiCo”). Review the Items 1, 1A, and 7 disclosures and describe how the review of the PepsiCo, Inc. disclosures might be informative to auditors of The Coca-Cola Company.

Chapter 9

REVIEW QUESTIONS

9-1 (Objective 9-1) Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of materiality and risk?

9-2 (Objective 9-1) 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?

9-3 (Objectives 9-1, 9-2) Explain why materiality is important but difficult to apply in practice.

9-4 (Objective 9-2) What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment.

9-5 (Objective 9-2) What is meant by using bases for setting a preliminary judgment about materiality? How will those bases differ for the audit of a manufacturing company and a government unit such as a school district?

9-6 (Objective 9-2) Assume that Rosanne Madden, CPA, is using 5% of net income before taxes, current assets, or current liabilities as her major guidelines for evaluating materiality. What qualitative factors should she also consider in deciding whether misstatements may be material?

9-7 (Objectives 9-2, 9-3) Distinguish between the terms tolerable misstatement and preliminary judgment about materiality. How are they related to each other?

9-8 (Objective 9-3) Assume a company with the following balance sheet accounts:

Account

Cash

Fixed assets

Amount

$10,000

60,000 _______

$70,000

Account

Long-term loans

M. Johnson, proprietor

Amount

$30,000

40,000 _______

$70,000

You are concerned only about overstatements 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.

9-9 (Objective 9-4) 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?

Chapter 9 / MATERIALITY AND RISK 275

9-10 (Objective 9-2) How will 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?

9-11 (Objective 9-6) Define the audit risk model and explain each term in the model. Also describe which two factors of the model when combined reflect the risk of material misstatement.

9-12 (Objective 9-6) 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?

9-13 (Objective 9-6) Explain the causes of an increased or decreased planned detection risk. 9-14 (Objectives 9-6, 9-8) Define what is meant by inherent risk. Identify four factors that

make for high inherent risk in audits.

9-15 (Objective 9-8) Explain why inherent risk is set for segments rather than for the 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 9-12.

9-16 (Objective 9-8) Explain the effect of extensive misstatements found in the prior year’s audit on inherent risk, planned detection risk, and planned audit evidence.

9-17 (Objectives 9-6, 9-7) Explain what is meant by the term acceptable audit risk. What is its relevance to evidence accumulation?

9-18 (Objective 9-7) Explain the relationship between acceptable audit risk and the legal liability of auditors.

9-19 (Objective 9-7) State the three categories of factors that affect acceptable audit risk and list the factors that the auditor can use to indicate the degree to which each category exists.

9-20 (Objective 9-9) 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 preciseAwpayaofgmoeasurPingDthFe riskE? nhancer

9-21 (Objective 9-10) 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.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

9-22 (Objectives 9-1, 9-2) The following questions deal with materiality. Choose the best response.

a. Which one of the following statements is correct concerning the concept of materiality?

(1) Materiality is determined by reference to guidelines established by the AICPA.

(2) Materiality depends only on the dollar amount of an item relative to other items

in the financial statements.

(3) Materiality depends on the nature of an item rather than the dollar amount.

(4) Materiality is a matter of professional judgment.

b. Which of the following is not correct about materiality?

(1) The concept of materiality recognizes that some matters are important for fair

presentation of financial statements in conformity with accounting standards,

whereas other matters are not important.

(2) An auditor considers materiality for planning purposes in terms of the largest

aggregate level of misstatements that could be considered material to any one of

the financial statements.

(3) Materialityjudgmentsaremadeinlightofsurroundingcircumstancesandneces-

sarily involve both quantitative and qualitative judgments.

(4) Anauditor’sconsiderationofmaterialityisinfluencedbytheauditor’sperception

of the needs of a reasonable person who will rely on the financial statements.

Part 2 / THE AUDIT PROCESS

276

c. In considering materiality for planning purposes, an auditor believes that misstate- ments aggregating $10,000 will have a material effect on an entity’s income statement, but that misstatements will have to aggregate $20,000 to materially affect the balance sheet. Ordinarily, it is appropriate to design audit procedures that are expected to detect misstatements that aggregate

(1) $10,000 (2) $15,000 (3) $20,000 (4) $30,000

9-23 (Objectives 9-6, 9-8) The following questions concern audit risk. Choose the best response.

a. Some account balances, such as those for pensions and leases, are the result of complex calculations. The susceptibility to material misstatements in these types of accounts is defined as

(1) audit risk.

(2) detection risk. (3) sampling risk. (4) inherent risk.

b. Inherent risk and control risk differ from planned detection risk in that they (1) arise from the misapplication of auditing procedures.

(2) may be assessed in either quantitative or nonquantitative terms.

(3) exist independently of the financial statement audit.

(4) can be changed at the auditor’s discretion.

c. Which of the following best describes the element of inherent risk that underlies the application of auditing standards?

(1) Cash audit work may have to be carried out in a more conclusive manner than

inventory audit work.

(2) Intercompanytransactionsareusuallysubjecttolessdetailedscrutinythanarm’s-

length transactions with outside parties.

(3) Inventories may require more attention by the auditor on an engagement for a

merchandising enterprise than on an engagement for a public utility.

(4) Thescopeoftheauditneednotbeexpandedifmisstatementsthatarousesuspicion

of fraud are of relatively insignificant amounts.

9-24 (Objective 9-9) The following questions deal with audit risk and evidence. Choose the best response.

a. As the acceptable level of detection risk decreases, an auditor may

(1) reducesubstantivetestingbyrelyingontheassessmentsofinherentriskandcontrol

risk.

(2) postponetheplannedtimingofsubstantivetestsfrominterimdatestotheyear-end.

(3) eliminatetheassessedlevelofinherentriskfromconsiderationasaplanningfactor.

(4) lowertheassessedlevelofcontrolriskfromthemaximumleveltobelowthemaximum.

b. As lower acceptable levels of both audit risk and materiality are established, the auditor should plan more work on individual accounts to

(1) find smaller misstatements.

(2) find larger misstatements.

(3) increase the tolerable misstatement in the accounts. (4) increase materiality in the accounts.

c. Based on evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor could

(1) decrease detection risk.

(2) increase materiality levels. (3) decrease substantive testing. (4) increase inherent risk.

Chapter 9 / MATERIALITY AND RISK 277

 

DISCUSSION QUESTIONS AND PROBLEMS

9-25 (Objectives 9-2, 9-3, 9-4) You are evaluating audit results for current assets in the audit of Quicky Plumbing Co. You set the preliminary judgment about materiality for current assets at $15,000 for overstatements and at $22,500 for understatements. The preliminary and actual estimates are shown next.

Account

Tolerable Misstatement

Estimate of Total Misstatement

Over- statements

Cash

Accounts receivable

Inventory 15,000 Prepaid expenses 3,000

Under- statements

$ 3,000 15,000 22,000

5,000 ________

$45,000 ________ ________

Over- statements

$ 1,000

9,000

14,000

2,000 ________

$26,000 ________ ________

Under- statements

$0

8,000

5,000

1,000 ________

$14,000 ________ ________

Total $30,000 ________ ________

$ 2,000 10,000

________

Required

a. Justify a lower preliminary judgment about materiality for overstatements than under- statements in this situation.

b. Explain why the totals of the tolerable misstatements exceed the preliminary judg- ments about materiality for both understatements and overstatements.

c. Explain how it is possible that three of the estimates of total misstatement have both an overstatement and an understatement.

d. Assume that you are not concerned whether the estimate of misstatement exceeds tolerable misstatement for individual accounts if the total estimate is less than the preliminary judgment.

(1) Given the audit results, should you be more concerned about the existence of

material overstatements or understatements at this point in the audit of Quicky Plumbing Co.?

(2) Which account or accounts will you be most concerned about in (1)? Explain.

e. Explain why the estimate of total overstatement amount for each account is less than tolerable misstatement, but that the total overstatement estimate exceeds the

preliminary judgment of materiality.

9-26 (Objectives 9-2, 9-3, 9-4) You are evaluating audit results for assets in the audit of Roberts Manufacturing. You set the preliminary judgment about materiality at $50,000. The account balances, tolerable misstatement, and estimated overstatements in the accounts are shown next.

Account Balance

Cash

Accounts receivable

Inventory 2,500,000 Other assets 250,000

Tolerable Misstatement

$ 5,000

30,000

50,000

15,000 ________

$100,000 ________ ________

Estimate of Total Overstatements

$ 1,000

20,000

?

12,000 _______

? _______ _______

Account

Required

a. Assume you tested inventory amounts totaling $1,000,000 and found $10,000 in overstatements. Ignoring sampling risk, what is your estimate of the total misstate- ment in inventory?

b. Based on the audit of the assets accounts and ignoring other accounts, are the overall financial statements acceptable? Explain.

c. What do you believe the auditor should do in the circumstances?

9-27 (Objectives 9-2, 9-3, 9-4) On pages 279–280 are statements of earnings and financial position for Wexler Industries.

Part 2 / THE AUDIT PROCESS

Total $4,000,000 __________ __________

$ 50,000 1,200,000

__________

278

Revenue

Net sales Other income

Costs and expenses

Cost of sales Marketing, general, and

administrative expenses Provision for loss on

restructured operations Interest expense

Earnings from continuing operations before income taxes

Income taxes

Earnings from continuing operations

Provision for loss on discontinued operations, net of income taxes

Net earnings

Assets

Current assets

Cash

Temporary investments, including time deposits

of $65,361 in 2011 and $181,589 in 2010

(at cost, which approximates market) Receivables, less allowances of $16,808 in 2011

and $17,616 in 2010 Inventories

Finished product

Raw materials and supplies

Deferred income tax benefits Prepaid expenses

Current assets

Land, buildings, and equipment, at cost,

less accumulated depreciation Investments in affiliated companies and

sundry assets

Goodwill and other intangible assets

Total

Consolidated Statements of Earnings Wexler Industries (in Thousands)

For the 53 Weeks Ended

March 30, 2011

For the 52 Weeks Ended

$8,351,149 59,675

$6,601,255 43,186

$5,959,587 52,418

_________

_________

_________

8,410,824

6,644,441

6,012,005

_________

_________

_________

March 31, 2010

April 1, 2009

5,197,375 2,590,080

4,005,548 2,119,590

3,675,369 1,828,169

64,100 141,662

— 46,737

— 38,546

_________

_________

_________

7,993,217

6,171,875

5,542,084

_________

_________

_________

417,607

(196,700) _________

220,907

(20,700) _________

472,566

(217,200) _________

255,366

— _________

469,921

(214,100) _________

255,821

— _________

$ 200,207

$ 255,366

$ 255,821

_________

_________

_________

 

Consolidated Statements of Financial Position Wexler Industries (in Thousands)

March 30, 2011

$ 39,683

123,421 899,752

680,974

443,175 _________

1,124,149 _________

March 31, 2010

_________

_________

9,633 57,468

10,468 35,911

2,254,106 1,393,902

2,018,787 1,004,455 83,455

112,938 99,791

23,145

_________

_________

$3,860,737

$3,129,842

_________

_________

$

353,795 _________

904,202 _________

37,566

271,639 759,001

550,407

Chapter 9 / MATERIALITY AND RISK 279

 

Required

Part 2 / THE AUDIT PROCESS

Liabilities and Stockholders’ Equity

Current liabilities

Notes payable

Current portion of long-term debt Accounts and drafts payable

Accrued salaries, wages, and vacations Accrued income taxes

Other accrued liabilities

Current liabilities

Long-term debt

Other noncurrent liabilities

Deferred income taxes

Stockholders’ equity

Common stock issued, 51,017,755 shares

in 2011 and 50,992,410 in 2010

Additional paid-in capital

Cumulative foreign currency translation adjustment Retained earnings

Common stock held in treasury, at cost, 1,566,598 shares Stockholders’ equity

Total

a. Use professional judgment in deciding on the preliminary judgment about materiality for earnings, current assets, current liabilities, and total assets. Your conclusions should be stated in terms of percents and dollars.

b. Assume that you define materiality for this audit as a combined misstatement of earnings from continuing operations before income taxes of 5%. Also assume that you believe there is an equal likelihood of a misstatement of every account in the financial

statements, and each misstatement is likely to result in an overstatement of earnings.

Allocate materiality to these financial statements as you consider appropriate.

c. As discussed in part b, net earnings from continuing operations before income taxes was used as a base for calculating materiality for the Wexler Industries audit. Discuss why most auditors use before-tax net earnings instead of after-tax net earnings when calculating materiality based on the income statement.

d. Now, assume that you have decided to allocate 75% of your preliminary judgment to accounts receivable, inventories, and accounts payable because you believe all other accounts have a low inherent and control risk. How does this affect evidence accumu- lation on the audit?

e. Assume that you complete the audit and conclude that your preliminary judgment about materiality for current assets, current liabilities, and total assets has been met. The actual estimate of misstatements in earnings exceeds your preliminary judgment. What should you do?

9-28 (Objectives 9-2, 9-3, 9-4, 9-6, 9-7, 9-8, 9-10) The following are concepts discussed in this chapter:

1. Preliminary judgment about materiality 2. Control risk

3. Risk of fraud

4. Estimated total misstatement in a segment 5. Planned detection risk

6. Estimate of the combined misstatement 7. Acceptable audit risk

8. Tolerable misstatement

9. Inherent risk

10. Risk of material misstatement 11. Known misstatement

March 30, 2011

March 31, 2010

$

280,238

64,594

359,511

112,200

76,479

321,871

$ 113,411

12,336

380,395

63,557

89,151

_________

269,672

1,214,893 730,987 146,687 142,344

51,018 149,177

(76,572) 1,554,170

928,522 390,687 80,586 119,715

50,992 148,584

— 1,462,723

(51,967)

(51,967)

_________

_________

1,625,826

1,610,332

_________

_________

$3,860,737

$3,129,842

_________

_________

_________

280

a. Identify which items are audit planning decisions requiring professional judgment.

b. Identify which items are audit conclusions resulting from application of audit pro-

cedures and requiring professional judgment.

c. Under what circumstances is it acceptable to change those items in part a after the audit is started? Which items can be changed after the audit is 95% completed?

9-29 (Objectives 9-6, 9-7) Describe what is meant by acceptable audit risk. Explain why each of the following statements is true:

a. A CPA firm should attempt to achieve the same audit risk for all audit clients when circumstances are similar.

b. A CPA firm should decrease acceptable audit risk for audit clients when external users rely heavily on the statements.

c. A CPA firm should decrease acceptable audit risk for audit clients when there is a reasonably high likelihood of a client filing bankruptcy.

d. Different CPA firms should attempt to achieve reasonably similar audit risks for clients with similar circumstances.

9-30 (Objective 9-7) Bohrer, CPA is considering the following factors in assessing audit risk at the financial statement level in planning the audit of Waste Remediation Services (WRS), Inc.’s financial statements for the year ended December 31, 2011. WRS is a privately-held company that contracts with municipal governments to close landfills. Audit risk at the financial statement level is influenced by the risk of material misstatements, which may be indicated by factors related to the entity, management, and the industry environment.

1. This was the first year WRS operated at a profit since 2006 because the munici- palities received increased federal and state funding for environmental purposes.

2. WRS’s Board of Directors is controlled by Tucker, the majority shareholder, who also

Required

acts as the chief executive officer.

3. The internal auditor reports to the controller and the controller reports to Tucker.

4. The accounting department has experienced a high rate of turnover of key personnel.

5. WRS’s bank has a loan officer who meets regularly with WRS’s CEO and controller

to monitor WRS’s financial performance.

6. WRS’s employees are paid bi-weekly.

7. Bohrer has audited WRS for five years.

8. During 2011, WRS changed its method of preparing its financial statements from

the cash basis to generally accepted accounting principles.

9. During 2011, WRS sold one half of its controlling interest in Sanitation Equipment

Leasing (SEL) Co. WRS retained a significant interest in SEL.

10. During 2011, litigation filed against WRS in 2001 alleging that WRS discharged pol-

lutants into state waterways was dropped by the state. Loss contingency disclosures that WRS included in prior years’ financial statements are being removed for the 2011 financial statements.

11. During December 2011, WRS signed a contract to lease disposal equipment from an entity owned by Tucker’s parents. This related party transaction is not disclosed in WRS’s notes to its 2011 financial statements.

12. During December 2011, WRS increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost.

13. WRS recorded a substantial increase in revenue in the fourth quarter of 2011. Inquiries indicated that WRS initiated a new policy and guaranteed several muni- cipalities that it would refund state and federal funding paid to WRS on behalf of the municipality if it failed a federal or state site inspection in 2012.

14. An initial public offering of WRS stock is planned in 2012.

For each of the 14 factors listed above, indicate whether the item would likely increase audit risk, decrease audit risk, or have no effect on audit risk.*

Required

*AICPA adapted.

Chapter 9 / MATERIALITY AND RISK 281

 

9-31 (Objective 9-6) Following are six situations that involve the audit risk model as it is used for planning audit evidence requirements. Numbers are used only to help you under- stand the relationships among factors in the risk model.

Situation

Risk 123456

Acceptable audit risk Inherent risk

Control risk

Planned detection risk

5% 5% 5% 100% 40% 60% 100% 60% 40%

— — —

5% 1% 1% 20% 100% 40% 30% 100% 60%

— — —

Required

a. Explain what each of the four risks means.

b. Calculate planned detection risk for each situation.

c. Which situation requires the greatest amount of evidence and which requires the least?

d. Using your knowledge of the relationships among the foregoing factors, state the effect on planned detection risk (increase or decrease) of changing each of the following factors while the other two remain constant:

(1) An increase in acceptable audit risk

(2) An increase in control risk

(3) A decrease in inherent risk

(4) An increase in control risk and a decrease in inherent risk of the same amount

9-32 (Objectives 9-6, 9-9) Following are six situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory.

Situation

Risk 123456

Required

a. Explain what low, medium, and high mean for each of the four risks and planned evidence.

b. Fill in the blanks for planned detection risk and planned evidence using the terms low, medium, or high.

c. Using your knowledge of the relationships among the foregoing factors, state the effect on planned evidence (increase or decrease) of changing each of the following five factors, while the other three remain constant:

(1) A decrease in acceptable audit risk

(2) A decrease in control risk

(3) A decrease in planned detection risk

(4) A decrease in inherent risk

(5) A decrease in inherent risk and an increase in control risk of the same amount

9-33 (Objectives 9-6) Below are ten independent risk factors:

1. The client lacks sufficient working capital to continue operations.

2. The client fails to detect employee theft of inventory from the warehouse because

there are no restrictions on warehouse access and the client does not reconcile

inventory on hand to recorded amounts on a timely basis.

3. The company is publicly traded.

4. The auditor has identified numerous material misstatements during prior year audit

engagements.

5. The assigned staff on the audit engagement lack the necessary skills to identify actual

errors in an account balance when examining audit evidence accumulated.

6. The client is one of the industry’s largest based on its size and market share.

Part 2 / THE AUDIT PROCESS

Acceptable audit risk High High Low Low

High Medium Medium Medium Medium Medium

— — — —

Inherent risk Low High High Low

Control risk

Planned detection risk Planned evidence

Low Low High High — — — — — — — —

282

7. The client engages in several material transactions with entities owned by family members of several of the client’s senior executives.

8. The allowance for doubtful accounts is based on significant assumptions made by management.

9. The audit plan omits several necessary audit procedures.

10. The client fails to reconcile bank accounts to recorded cash balances.

Identify which of the following audit risk model components relates most directly to each of the ten risk factors:

• Acceptable audit risk

• Inherent risk

• Control risk

• Planned detection risk

9-34 (Objectives 9-6, 9-10) Using the audit risk model, state the effect on control risk, inherent risk, acceptable audit risk, and planned evidence for each of the following independent events. In each of the events a to j, circle one letter for each of the three independent variables and planned evidence: I = increase, D = decrease, N = no effect, and C = cannot determine from the information provided.

Required

a.

b.

c.

d.

e.

f .

g.

h.

The client’s management materially decreased long-term contractual debt: Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

The company changed from a privately held company to a publicly held company: Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

The auditor decided to set assessed control risk at the maximum (it was previously

assessed below the maximum):

Control risk I D N C Acceptable audit risk I D N C

Inherent risk I D N C Planned evidence I D N C

The account balance increased materially from the preceding year without apparent reason:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

You determined through the planning phase that working capital, debt-to-equity ratio, and other indicators of financial condition improved during the past year: Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

This is the second year of the engagement, and there were few misstatements found in the previous year’s audit. The auditor also decided to increase reliance on internal control:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

The client began selling products online to customers through its Web page during the year under audit. The online customer ordering process is not integrated with the company’s accounting system. Client sales staff print out customer order information and enter that data into the sales accounting system:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

There has been a change in several key management personnel. You believe that management is somewhat lacking in personal integrity compared with the previous management. You believe it is still appropriate to do the audit:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

Chapter 9 / MATERIALITY AND RISK 283

 

Required

the complexities of the underlying accounting associated with these activities, Henderson Energy added several highly experienced accountants within its financial reporting team. Internal audit, which has direct reporting responsibility to the audit committee, is also actively involved in reviewing key accounting assumptions and estimates on a quarterly basis.

Whitehead’s discussions with the predecessor auditor revealed that the client has experienced some difficulty in correctly tracking existing property, plant, and equipment items. This largely involves equipment located at its multiple energy production facilities. During the recent year, Henderson acquired a regional electric company, which expanded the number of energy production facilities.

Whitehead plans to staff the audit engagement with several members of the firm who have experience in auditing energy and public companies. The extent of partner review of key accounts will be extensive.

Based on the above information, identify factors that affect the risk of material mis- statement in the December 31, 2011 financial statements of Henderson Energy. Indicate whether the factor increases or decreases the risk of material misstatement. Also, identify which audit risk model component is affected by the factor. Use the format below:

i . In auditing inventory, you obtain an understanding of internal control and perform tests of controls. You find it significantly improved compared with that of the preceding year. You also observe that because of technology changes in the industry, the client’s inventory may be somewhat obsolete:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

j . In discussions with management, you conclude that management is planning to sell the business in the next few months. Because of the planned changes, several key accounting personnel quit several months ago for alternative employment. You also observe that the gross margin percent has significantly increased compared with that of the preceding year:

Control risk I D N C Acceptable audit risk I D N C Inherent risk I D N C Planned evidence I D N C

CASES

9-35 (Objectives 9-6, 9-7, 9-8) Whitehead, CPA, is planning the audit of a newly obtained client, Henderson Energy Corporation, for the year ended December 31, 2011. Henderson Energy is regulated by the state utility commission and because it is a publicly traded company the audited financial statements must be filed with the Securities and Exchange Commission (SEC).

Henderson Energy is considerably more profitable than many of its competitors,

largely due to its extensive investment in information technologies used in its energy

distribution and other key business processes. Recent growth into rural markets,

however, has placed some strain on 2011 operations. Additionally, Henderson Energy

expanded its investments into speculative markets and is also making greater use of

derivative and hedging transactions to mitigate some of its investment risks. Because of

Effect on the Risk of

Factor Material Misstatement

Henderson is a new client Increases

Audit Risk Model

Component

Inherent risk

Part 2 / THE AUDIT PROCESS

9-36 (Objectives 9-2, 9-3, 9-6, 9-7, 9-8) Pamela Albright is the manager of the audit of Stanton Enterprises, a public company that manufactures formed steel subassemblies for other manufacturers. Albright is planning the 2011 audit and is considering an appropriate amount for planning materiality, what tolerable misstatement should be allocated to the financial statement accounts, and the appropriate inherent risks. Summary financial

284

FIGURE 9-8 Stanton Enterprises Summary Financial Statements Balance Sheet

Preliminary 12-31-11

Audited 12-31-10

133,981 2,224,921

(215,000) 3,888,400 24,700

6,057,002

9,922,534 (3,775,911)

6,146,623

345,000

$12,548,625

$ Inventories 4,520,902

Cash

Trade accounts receivable Allowance for uncollectible accounts

243,689 3,544,009

$

Prepaid expenses

Total current assets

Property, plant, and equipment: At cost

Less accumulated depreciation

Total prop., plant, and equipment

29,500

8,218,100 12,945,255

(4,382,990)

8,562,265

(120,000)

Goodwill 1,200,000

Total assets

Accounts payable

Bank loan payable

Accrued liabilities

Federal income taxes payable Current portion of long-term debt

Total current liabilities Long-term debt

Stockholders’ equity: Common stock Additional paid-in capital Retained earnings

Total stockholders’ equity

Total liabilities and stockholders’ equity

$17,980,365

$

$17,980,365

2,141,552 150,000 723,600

1,200,000 240,000

4,455,152 960,000

1,250,000 2,469,921 8,845,292

12,565,213

$

$12,548,625

2,526,789 —

598,020 1,759,000 240,000

5,123,809 1,200,000

1,000,000 1,333,801 3,891,015 6,224,816

 

Combined Statement of Income and Retained Earnings

Sales

Cost of goods sold

Gross profit

Selling, general, and administrative expenses Pension cost

Interest expense

Total operating expenses

Income before taxes

Income tax expense

Net income

Beginning retained earnings

Dividends declared Ending retained earnings

Preliminary 12-31-11

$ 43,994,931 24,197,212

19,797,719 10,592,221 1,117,845 83,376

11,793,442

8,004,277 1,800,000

6,204,277 3,891,015

10,095,292 (1,250,000)

$ 8,845,292

Audited 12-31-10

$32,258,015 19,032,229

13,225,786 8,900,432 865,030 104,220

9,869,682

3,356,104 1,141,000

2,215,104 2,675,911 4,891,015 (1,000,000)

$ 3,891,015

statement information is shown in Figure 9-8. Additional relevant planning information is summarized next.

1. Stanton has been a client for 4 years, and Albright’s firm has always had a good rela- tionship with the company. Management and the accounting people have always been cooperative, honest, and positive about the audit and financial reporting. No material misstatements were found in the prior year’s audit. Albright’s firm has monitored the relationship carefully, because when the audit was obtained, Leonard Stanton, the CEO, had the reputation of being a “high-flyer” and had been through bankruptcy at an earlier time in his career.

Chapter 9 / MATERIALITY AND RISK 285

 

FIGURE 9-9

2. Stanton runs the company in an autocratic way, primarily because of a somewhat controlling personality. He believes that it is his job to make all the tough decisions. He delegates responsibility to others but is not always willing to delegate a commen- surate amount of authority.

3. The industry in which Stanton participates has been in a favorable cycle the past few years and that trend is continuing in the current year. Industry profits are reasonably favorable, and there are no competitive or other apparent threats on the horizon.

4. Internal controls for Stanton are evaluated as reasonably effective for all cycles but not unusually strong. Although Stanton supports the idea of control, Albright has been disappointed that management has continually rejected Albright’s recom- mendation to improve its internal audit function.

5. Stanton has a contract with its employees that if earnings before taxes, interest expense, and pension cost exceed $7.8 million for the year, an additional contribu- tion must be made to the pension fund equal to 5% of the excess.

Stanton Enterprises Evidence-Planning Worksheet to Decide Tests of Details of Balances for Accounts Receivable

Acceptable audit risk

Inherent risk

Control risk—Sales

Control risk— Cash receipts

Control risk— Additional controls

Substantive tests of transactions—Sales

Substantive tests of transactions—

Cash receipts

Analytical procedures

Planned detection risk for tests of details of balances

Planned audit evidence for tests of details of balances

Tolerable misstatement

286

Part 2 / THE AUDIT PROCESS

Detail tie-in

Existence

Completeness

Accuracy

Classification

Cutoff

Realizable value

Rights

a. You are to play the role of Pamela Albright in the 12-31-11 audit of Stanton Enterprises. Required Make a preliminary judgment of materiality and allocate tolerable misstatement to

financial statement accounts. Prepare an audit schedule showing your calculations.

(Instructor option: prepare the schedule using an electronic spreadsheet.)

b. Make an acceptable audit risk decision for the current year as high, medium, or low, and support your answer.

c. Perform analytical procedures for Stanton Enterprises that will help you identify accounts that may require additional evidence in the current year’s audit. Document the analytical procedures you perform and your conclusions. (Instructor option: use an electronic spreadsheet to calculate analytical procedures.)

d. The evidence planning worksheet to decide tests of details of balances for Stanton’s accounts receivable is shown in Figure 9-9. Use the information in the case and your conclusions in parts a–c to complete the following rows of the evidence-planning worksheet: Acceptable audit risk, Inherent risk, and Analytical procedures. Also fill in tolerable misstatement for accounts receivable at the bottom of the worksheet. Make any assumptions you believe are reasonable and appropriate and document them.

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART II

9-37 (Objectives 9-7, 9-8)

In Part I of the case, you performed preliminary analytical procedures for Pinnacle (pp. 245–247). The purpose of Part II is to identify factors influencing risks and the relationship of risks to audit evidence.

believe may be relevant to the audit:

1. Your firm has an employee who reads and saves articles about issues that may affect key clients. You read an article in the file titled, “EPA Regulations Encouraging Solar- Powered Engines Postponed?” After reading the article, you realize that the regula- tions management is relying upon to increase sales of the Solar-Electro division might not go into effect for at least ten years. A second article is titled, “Stick to Diesel Pinnacle!” The article claims that although Pinnacle has proven itself within the diesel engine industry, they lack the knowledge and people necessary to perform well in the solar-powered engine industry.

2. You ask management for a tour of the Solar-Electro facilities. While touring the warehouse, you notice a section of solar-powered engines that do not look like the ones advertised on Pinnacle’s Web site. You ask the warehouse manager when those items were first manufactured. He responds by telling you, “I’m not sure. I’ve been here a year and they were here when I first arrived.”

3. You also observe that new computerized manufacturing equipment has been installed at Solar-Electro. The machines have been stamped with the words, “Product of Welburn Manufacturing, Detroit, Michigan.”

4. During discussions with the Pinnacle controller, you learn that Pinnacle employees did a significant amount of the construction work for a building addition because of employee idle time and to save costs. The controller stated that the work was carefully coordinated with the construction company responsible for the addition.

5. While reading the footnotes of the previous year’s financial statements, you note that one customer, Auto-Electro, accounts for nearly 15% of the company’s accounts receivable balance. You investigate this receivable and learn the customer has not made any payments for several months.

6. During a meeting with the facilities director, you learn that the board of directors has decided to raise a significant amount of debt to finance the construction of a new

During the planning phase of the audit, you met with Pinnacle’s management team and performed other planning activities. You encounter the following situations that you

Chapter 9 / MATERIALITY AND RISK 287

 

Required

manufacturing plant for the Solar-Electro division. The company also plans to make a considerable investment in modifications to the property on which the plant will be built.

7. While standing in line at a vending machine, you see a Pinnacle vice president wearing a golf shirt with the words “Todd-Machinery.” You are familiar with the company and noticed some of its repairmen working in the plant earlier. You tell the man you like the shirt and he responds by saying, “Thank you. My wife and I own the company, but we hire people to manage it.”

8. After inquiry of the internal audit team, you realize there is significant turnover in the internal audit department. You conclude the turnover is only present at the higher-level positions.

9. While reviewing Pinnacle’s long-term debt agreements, you identify several restric- tive covenants. Two requirements are to keep the current ratio above 2.0 and debt- to-equity below 1.0 at all times.

10. The engagement partner from your CPA firm called today notifying you that Brian Sioux, an industry specialist and senior tax manager from the firm’s Ontario office, will be coming on-site to Pinnacle’s facilities to investigate an ongoing dispute between the Internal Revenue Service and Pinnacle.

11. A member of your CPA firm, who is currently on-site in Detroit at the Welburn division, calls you to see how everything is going while you are visiting Solar-Electro in Texas. During your conversation, he asks if you know anything about the recent intercompany loan from Welburn to Solar-Electro.

a. Review Part I of the case and the situations in Part II and identify information that affects your assessment of acceptable audit risk. Note that only some of the situations in Part II will relate to acceptable audit risk. Classify the information based on the three factors that affect acceptable audit risk.

External users’ reliance on financial statements

Likelihood of financial difficulties

Management integrity

b. Assess acceptable audit risk as high, medium, or low considering the items you identi- fied in requirement a. (A risky client will be assessed as a low acceptable audit risk.) Justify your response.

c. Identify inherent risks for the audit of Pinnacle using the information from Parts I and II. For each inherent risk, identify the account or accounts that may be affected.

Inherent Risk Account or Accounts Affected

INTERNET PROBLEM 9-1:

MATERIALITY AND TOLERABLE MISSTATEMENT

Required

Establishing materiality and allocation of materiality to individual accounts requires con- siderable judgment. Access Microsoft’s 2009 financial statements at http://www.microsoft.com (use the “investor relations” link).

a. Assume that your firm’s materiality guidelines indicate that materiality should be between three and six percent of net income before taxes. What percentage and dollar amount of materiality would you use for the audit of Microsoft? Explain.

b. What asset accounts on Microsoft’s balance sheet should be allocated the largest amount of tolerable misstatement? Explain.

Chapter 10

10-1 (Objective 10-1) Describe the three

ing effective internal control.

10-2 (Objective 10-1) Describe which of the three categories of broad objectives for internal controls are considered by the auditor in an audit of both the financial statements and internal control over financial reporting.

10-3 (Objective 10-2) Section 404(a) of the Sarbanes–Oxley Act requires management to issue a report on internal control over financial reporting. Identify the specific Section 404(a) reporting requirements for management.

10-4 (Objective 10-2) What two aspects of internal control must management assess when reporting on internal control to comply with Section 404 of the Sarbanes–Oxley Act?

10-5 (Objective 10-2) Chapter 8 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 control risk?

person(s) with responsibility for over- seeing the strategic direction of the entity and its obligations related to the account- ability of the entity, including overseeing the financial reporting and disclosure process

Walkthrough—the tracing of selected trans- actions through the accounting system to determine that controls are in place

broad objectives management has when design-

322

10-6 (Objectives 10-2, 10-4, 10-8) What is the auditor’s responsibility for obtaining an understanding of internal control? How does that responsibility differ for audits of public and nonpublic companies?

10-7 (Objective 10-2) When performing an integrated audit of a public company, what are the auditor’s responsibilities related to internal control as required by PCAOB standards?

10-8 (Objectives 10-2, 10-5) State the six transaction-related audit objectives.

10-9 (Objectives 10-2, 10-3) 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?

10-10 (Objective 10-3) What are the five components of internal control in the COSO internal control framework?

10-11 (Objective 10-3) What is meant by the control environment? What are the factors the auditor must evaluate to understand it?

10-12 (Objective 10-3) What is the relationship among the five components of internal control?

10-13 (Objective 10-3) List the types of specific control activities and provide one specific illustration of a control in the sales area for each control activity.

10-14 (Objective 10-3) 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.

10-15 (Objective 10-3) 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

10-16 (Objective 10-3) Explain what is meant by independent checks on performance and give five specific examples.

10-17 (Objective 10-4) Describe the four phases performed by the auditor when obtaining an understanding of internal control and assessing control risk.

10-18 (Objective 10-4) What two aspects of internal control must the auditor assess when performing procedures to obtain an understanding of internal control?

10-19 (Objective 10-4) What is a walkthrough of internal control? What is its purpose? 10-20 (Objective 10-4) Describe how the nature of evidence used to evaluate the control

environment differs from the nature of evidence used to evaluate control activities.

10-21 (Objectives 10-5, 10-7) Distinguish a significant deficiency in internal control from a material weakness in internal control. How will the presence of one significant deficiency affect an auditor’s report on internal control under PCAOB standards? How will the presence of one material weakness affect an auditor’s report on internal control under PCAOB standards?

10-22 (Objectives 10-3, 10-5) 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 had always been exceptional, and over the years, he had been given increased responsibility. Both the 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 embezzlement to take place?

10-23 (Objective 10-5) Jeanne Maier, CPA, believes that it is appropriate to obtain an understanding of internal control about halfway through the audit, after she is familiar with the client’s operations and the way the system actually works. She has found through

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 323

 

experience that 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 the engagement, the auditor can prepare flowcharts and questionnaires with relative ease because of the knowledge already obtained on the audit. Evaluate her approach. 10-24 (Objectives 10-6, 10-8) Distinguish the auditor’s responsibility for testing controls in an integrated audit of a public company from the responsibility to test controls in an audit of a nonpublic company.

10-25 (Objective 10-6) Describe why auditors generally evaluate entity-level controls before evaluating transaction-level controls.

10-26 (Objective 10-6) During the prior-year audits of McKimmon Inc., a private 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.

10-27 (Objective 10-6) The auditor’s risk assessment procedures identified several risks that the auditor deems to be significant risks. Several internal controls exist that are designed to mitigate the risks identified. Describe the auditor’s responsibilities for considering those controls in the current audit.

10-28 (Objective 10-7) 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?

10-29 (Objective 10-7) Describe the concept of an integrated audit of the financial state- ments and internal control required by PCAOB standards.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

Part 2 / THE AUDIT PROCESS

10-30 (Objectives 10-1, 10-2, 10-7) The following are general questions about internal

control. Choose the best response.

a. When considering internal control, an auditor must be aware of the concept of reason-

able assurance, which recognizes that the

(1) employment of competent personnel provides assurance that management’s control

objectives will be achieved.

(2) establishment and maintenance of internal control is an important responsibility

of management and not of the auditor.

(3) cost of internal control should not exceed the benefits expected to be derived therefrom. (4) separation of incompatible functions is necessary to ascertain that the internal

control is effective.

b. Actions, policies, and procedures that reflect the overall attitude of management,

directors and owners of the entity about internal control relate to which of the following internal control components?

(1) Control environment (3) Risk assessment

(2) Information and communication (4) Monitoring

c. Vendor account reconciliations are performed by three clerks in the accounts payable department on Friday of each week. The accounts payable supervisor reviews the completed reconciliations the following Monday to ensure they have been completed. The work performed by the supervisor is an example of which COSO component? (1) Control activities (3) Risk assessment

(2) Information and communication (4) Monitoring

d. What is the independent auditor’s principal purpose for obtaining an understanding

of internal control and assessing control risk in a financial statement audit? (1) To comply with generally accepted accounting principles.

(2) To obtain a measure of assurance of management’s efficiency.

(3) To maintain a state of independence in mental attitude during the audit. (4) To determine the nature, timing, and extent of subsequent audit work.

324

10-31 (Objectives 10-5, 10-7) The following questions deal with deficiencies in internal control. Choose the best response.

a. Which of the following is an example of an operation deficiency in internal control?

(1) The company does not have a code of conduct for employees to consider.

(2) The cashier has online ability to post write-offs to accounts receivable accounts.

(3) Clerks who conduct monthly reconciliation of intercompany accounts do not

understand the nature of misstatements that could occur in those accounts.

(4) Management does not have a process to identify and assess risks on a recurring

basis.

b. A material weakness in internal control represents a control deficiency that

(1) more than remotely adversely affects a company’s ability to initiate, authorize, record, process, or report external financial statements reliably.

(2) results in a reasonable possibility that internal control will not prevent or detect material financial statement misstatements.

(3) exists because a necessary control is missing or not properly designed.

(4) reduces the efficiency and effectiveness of the entity’s operations.

c. An auditor of a large public company identifies a material weakness in internal control.

The auditor

(1) will be unable to issue an unqualified opinion on the financial statements.

(2) must issue a qualified or disclaimer of opinion on internal control over financial

reporting.

(3) may still be able to issue an unqualified opinion on internal control over financial

reporting.

(4) must issue an adverse opinion on internal control over financial reporting.

d. When a nonpublic company auditor’s tests of controls identify deficiencies in internal control over financial reporting, the auditor

(1) must communicate to management all deficiencies identified.

(2) must communicate both significant deficiencies and material weaknesses to those

charged with governance.

(3) may communicate orally or in writing to the board all significant deficiencies and

material weaknesses identified.

(4) must issue an adverse opinion on the financial statements.

10-32 (Objectives 10-5, 10-6, 10-8) The following questions deal with assessing control risk in a financial statement audit. Choose the best response.

a. The auditor’s tests of controls revealed that required approvals of cash disbursements were absent for a large number of sample transactions examined. Which of the follow- ing is least likely to be the appropriate auditor response?

(1) The auditor will communicate the deficiency to those charged with governance.

(2) The auditor will increase the planned detection risk.

(3) The auditor will not select more sample items to audit.

(4) The auditor will perform more extensive substantive tests surrounding cash dis-

bursements.

b. An auditor uses assessed control risk to

(1) evaluate the effectiveness of the entity’s internal controls.

(2) identify transactions and account balances where inherent risk is at the maximum. (3) indicate whether materiality thresholds for planning and evaluation purposes are

sufficiently high.

(4) determine the acceptable level of detection risk for financial statement assertions.

c. On the basis of audit evidence gathered and evaluated, an auditor decides to increase assessed control risk from that originally planned. To achieve an audit risk level (AcAR) that is substantially the same as the planned audit risk level (AAR), the auditor will (1) increase inherent risk.

(2) increase materiality levels.

(3) decrease substantive testing.

(4) decrease planned detection risk.

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 325

 

d. Which of the following statements about tests of controls is incorrect? Tests of controls (1) must be done in every audit of an accelerated filer public company’s financial

statements.

(2) provide persuasive evidence that a material misstatement exists when the auditor

determines that the control is not being consistently applied.

(3) are often based on the same types of audit techniques used to gain an understanding of internal controls, except the extent of testing is generally greater when testing controls. (4) allow a reduction in the extent of substantive testing, as long as the results of the

tests of controls are equal to or better than what the auditor expects.

DISCUSSION QUESTIONS AND PROBLEMS

Required

and authorization protocols.

9. The compensation committee reviews compensation plans for senior executives to

determine if those plans create unintended pressures that might lead to distorted

financial statements.

10. On a monthly basis, department heads review a budget to actual performance report

and investigate unusual differences.

Indicate which of the five COSO internal control components is best represented by each internal control.

a. Control environment d. Information and communication b. Risk assessment e. Monitoring

c. Control activities

10-34 (Objectives 10-3, 10-4, 10-5, 10-6) Each of the following internal controls has been taken from a standard internal control questionnaire used by a CPA firm for assessing control risk in the payroll and personnel cycle.

1. Approval of department head or foreman on time cards is required before preparing payroll.

2. All prenumbered time cards are accounted for before beginning data entry for preparation of checks.

3. The computer calculates gross and net pay based on hours inputted and information in employee master files, and payroll accounting personnel double-check the mathe- matical accuracy on a test basis.

4. All voided and spoiled payroll checks are properly mutilated and retained.

5. Human resources policies require an investigation of an employment application from new employees. Investigation includes checking the employee’s background,

former employers, and references.

Part 2 / THE AUDIT PROCESS

10-33 (Objective 10-3) Following are descriptions of ten internal controls.

1. The company’s computer systems track individual transactions and automatically

accumulate transactions to create a trial balance.

2. The company must receive university transcripts documenting all college degrees

earned before an individual can begin their first day of employment with the company.

3. Senior management obtains data about external events that might affect the entity

and evaluates the impact of that information on its existing accounting processes.

4. Each quarter, department managers are required to perform a self-assessment of the department’s compliance with company policies. Reports summarizing the results

are to be submitted to the senior executive overseeing that department.

5. Before a cash disbursement can be processed, all payee information must be verified

by matching the payee to the company’s approved vendor listing.

6. The system automatically reconciles the detailed accounts receivable subsidiary

ledger to the accounts receivable general ledger account on daily basis.

7. The company has developed a detailed series of accounting policy and procedures

manuals to help provide detailed instructions to employees about how controls are

to be performed.

8. The company has an organizational chart that establishes the formal lines of reporting

326

6. The payroll accounting software application will not accept data input for an employee number not contained in the employee master file.

7. Persons preparing the payroll do not perform other payroll duties (timekeeping, dis- tribution of checks) or have access to payroll data master files or cash.

8. Written termination notices, with properly documented reasons for termination, and approval of an appropriate official are required.

9. All checks not distributed to employees are returned to the treasurer for safekeeping.

10. Online ability to add employees or change pay rates to the payroll master file is

restricted via passwords to authorized human resource personnel.

a. For each internal control, identify the type(s) of specific control activity (activities) to which it applies (such as adequate documents and records or physical control over assets and records).

b. For each internal control, identify the transaction-related audit objective(s) to which it applies.

c. For each internal control, identify a specific misstatement that is likely to be prevented if the control exists and is effective.

d. For each control, list a specific misstatement that could result from the absence of the control.

e. For each control, identify one audit test that the auditor could use to uncover mis- statements resulting from the absence of the control.

10-35 (Objectives 10-3, 10-4, 10-5) The following are misstatements that have occurred in Fresh Foods Grocery Store, a retail and wholesale grocery company:

1. The incorrect price was used on sales invoices for billing shipments to customers because the wrong price was entered into the computer master file of prices.

Required

2. A vendor invoice was paid even though no merchandise was ever received. The accounts payable software application does not require the input of a valid receiving report number before payment can be made.

3. Employees in the receiving depaArtmpenat tgook sidPes oDf bFeef fEornthehirapernsocnael urse. When a shipment of meat was received, the receiving department filled out a receiving report and forwarded it to the accounting department for the amount of goods actually received. At that time, two sides of beef were put in an employee’s pickup truck rather than in the storage freezer.

4. During the physical count of inventory of the retail grocery, one counter wrote down the wrong description of several products and miscounted the quantity.

5. A salesperson sold an entire carload of lamb at a price below cost because she did not know the cost of lamb had increased in the past week.

6. A vendor’s invoice was paid twice for the same shipment. The second payment arose because the vendor sent a duplicate copy of the original 2 weeks after the payment was due.

7. On the last day of the year, a truckload of beef was set aside for shipment but was not shipped. Because it was still on hand the inventory was counted. The shipping docu- ment was dated the last day of the year, so it was also included as a current-year sale.

8. An accounts payable clerk processed payments to himself by adding a fictitious vendor address to the approved vendor master file.

a. For each misstatement, identify one or more types of controls that were absent.

b. For each misstatement, identify the transaction-related audit objectives that have not been met.

c. For each misstatement, suggest a control to correct the deficiency.

10-36 (Objective 10-3) The division of the following duties is meant to provide the best possible controls for the Meridian Paint Company, a small wholesale store:

†1. Approve credit for customers included in the customer credit master file.

†2. Input shipping and billing information to bill customers, record invoices in the sales

journal, and update the accounts receivable master file.

†3. Open the mail and prepare a prelisting of cash receipts.

Required

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 327

 

Required

†4. Enter cash receipts data to prepare the cash receipts journal and update the accounts receivable master file.

†5. Prepare daily cash deposits.

†6. Deliver daily cash deposits to the bank.

†7. Assemble the payroll time cards and input the data to prepare payroll checks and

update the payroll journal and payroll master files.

†8. Sign payroll checks.

†9. Assemble supporting documents for general and payroll cash disbursements.

†10. Sign general cash disbursement checks.

†11. Input information to prepare checks for signature, record checks in the cash dis-

bursements journal, and update the appropriate master files.

†12. Mail checks to suppliers and deliver checks to employees.

13. Cancel supporting documents to prevent their reuse.

14. Update the general ledger at the end of each month and review all accounts for un-

expected balances.

15. Reconcile the accounts receivable master file with the control account and review

accounts outstanding more than 90 days.

16. Prepare monthly statements for customers by printing the accounts receivable

master file; then mail the statements to customers.

17. Reconcile the monthly statements from vendors with the accounts payable master

file.

18. Reconcile the bank account.

You are to divide the accounting-related duties 1 through 18 among Robert Smith, James Cooper, and Bill Miller. All of the responsibilities marked with a dagger are assumed to take about the same amount of time and must be divided equally between Smith and Cooper. Both employees are equally competent. Miller, who is president of the company, is not willing to perform any functions designated by a dagger and will perform only a maximum of two of the other functions.*

10-37 (Objectives 10-2, 10-4, 10-8) Lew Pherson and Vera Collier are friends who are employed by different CPA firms. One day during lunch they are discussing the importance of internal control in determining the amount of audit evidence required for an engage- ment. Pherson expresses the view that internal control must be evaluated carefully in all companies, regardless of their size or whether they are publicly held, in a similar manner. His CPA firm requires a standard internal control questionnaire on every audit as well as a flowchart of every transaction area. In addition, he says the firm requires a careful evaluation of the system and a modification in the evidence accumulated based on the controls and deficiencies in the system.

Collier responds by saying she believes that internal control cannot be adequate in many of the small companies she audits; therefore, she simply ignores internal control and acts under the assumption of inadequate controls. She goes on to say, “Why should I spend a lot of time obtaining an understanding of internal control and assessing control risk when I know it has all kinds of weaknesses before I start? I would rather spend the time it takes to fill out all those forms in testing whether the statements are correct.”

a. Express in general terms the most important difference between the nature of the potential controls available for large and small companies.

b. Criticize the positions taken by Pherson and Collier, and express your own opinion about the similarities and differences that should exist in understanding internal control and assessing control risk for different-sized companies.

c. Discuss whether Collier’s approach is acceptable under existing auditing standards for either public or nonpublic companies.

d. Describe what additional procedures Pherson must perform if auditing the financial statements of a public company.

*AICPA adapted.

Required

Part 2 / THE AUDIT PROCESS

328

10-38 (Objectives 10-3, 10-5) The following are partial descriptions of internal controls for companies engaged in the manufacturing business:

1. When Mr. Clark orders materials, he sends a duplicate purchase order to the receiving department. During the delivery of materials, Mr. Smith, the receiving clerk, records the receipt of shipment on this purchase order and then sends the purchase order to the accounting department, where it is used to record materials purchased and accounts payable. The materials are transported to the storage area by forklifts. The additional purchased quantities are recorded on storage records.

2. Every day, hundreds of employees clock in using time cards at Generous Motors Corporation. The timekeepers collect these cards once a week and deliver them to the computer department, which handles data entry. There, the data on these time cards are entered into the computer. The entered data is used in the preparation of the labor cost distribution records, the payroll journal, and the payroll checks. The treasurer, Mrs. Webber, compares the payroll journal with the payroll checks, signs the checks, and returns them to Mr. Strode, the supervisor of the computer depart- ment. The payroll checks are distributed to the employees by Mr. Strode.

3. The smallest branch of Connor Cosmetics employs Mary Cooper, the branch manager, and her sales assistant, Janet Hendrix. The branch uses a bank account to pay expenses. The account is kept in the name of “Connor Cosmetics—Special Account.” To pay expenses, checks must be signed by Mary Cooper or by the treasurer, John Winters. Cooper receives the cancelled checks and bank statements. She reconciles the branch account herself and files cancelled checks and bank statements in her records. She also periodically prepares reports of cash disbursements and sends them to the home office.

a. List the deficiencies in internal control for each of these situations. To identify the deficiencies, use the methodology that was discussed in this chapter.

b. For each deficiency, state the type(s) of misstatement(s) that is (are) likely to result. Be as specific as possible.

Required

Required

Required

c. How would you improve internal controls for each of the three companies?*

10-39 (Objective 10-5) Anthony, CPA, prepared the flowchart (p. 330) which portrays the raw materials purchasing function of one of Anthony’s clients, Medium-Sized Manufacturing Company, from the preparation of initial documents through the vouching of invoices for payment in accounts payable. Assume that all documents are prenumbered.

Identify the deficiencies in internal control that can be determined from the flowchart. Use the methodology discussed in this chapter. Include internal control deficiencies resulting from activities performed or not performed.*

10-40 (Objective 10-6) The following internal controls were tested in prior audits. Evaluate each internal control independently and determine which controls must be tested in the current year’s audit of the December 31, 2011 financial statements. Be sure to explain why testing is or is not required in the current year.

1. The general ledger accounting software system automatically reconciles totals in each of the subsidiary master files for accounts receivable, accounts payable, and inventory accounts to the respective general ledger accounts. This control was most recently tested in the prior year. No changes to the software have been made since testing and there are strong controls over IT security and software program changes.

2. The accounts payable clerk matches vendor invoices with related purchaser orders and receiving reports and investigates any differences noted. This control was tested in the 2010 fiscal year end audit. No changes to this control or personnel involved have occurred since testing was performed.

3. The sales system automatically determines whether a customer’s purchase order and related accounts receivable balance are within the customer’s credit limit. The risk of shipping goods to customers who exceed their credit limit is deemed to be a significant risk. This control was last tested in the December 31, 2009 financial statement audit.

*AICPA adapted.

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 329

 

MEDIUM-SIZED MANUFACTURING COMPANY FLOWCHART OF RAW MATERIALS PURCHASING FUNCTION

Date Prepared by

Approved by

MANUFACTURING DIVISION

ACCOUNTS PAYABLE

STORES

PURCHASE OFFICE

RECEIVING ROOM

CONTROLLER’S DIVISION

Purchase requisition 1

Purchase requisition 2

By requisition no.

Purchase order 3

Purchase order 4

By vendor

Purchase order 4

Receiving report 1

Inv.

F

Voucher with documents

G

By purchase order

Purchase order 3

D

Purchase order 3

Receiving report 1

2

3

By vendor

A

Purchase requisition1

By Purchase requisition To order 1

no. vendor 23 4

Purchase order 5

Purchase requisition3

C

Purchase order 5

Req.

23B

Purchase requisition1

C

Purchase order 6

Req. 1

By purchase order

5

6

3

Explanatory Notes

A. Prepare purchase requisition (3 copies) as needed.

B. Prepare purchase order (6 copies).

C. Attach purchase

Purchase order 6

 

1

Receiving

report

E

Enhancer

requisition to Req.

p

urch

ase

order.

D. Merchandise received, From counted, and receiving vendor report (3 copies)

prepared based on

count and purchase

order. Invoice E. Match purchase order,

1

purchase requisition, receiving report, and invoice.

F. Prepare voucher after comparing data on purchase order, invoice, receiving report.

2

By purchase order

Receiving report 2

P.O. 6

Receiving report 1

Inv.

G. To cash disbursements Req. in controller’s division

for payment.

Req. 􏰅 Purchase

requisition P.O. 􏰅 Purchase order

Inv. 􏰅 Invoice

1

4. The perpetual inventory system automatically extends the unit price times quantity for inventory on hand. This control was last tested in the audit of December 31, 2009 financial statements. During 2011, the client made changes to this software system.

5. The client’s purchase accounting system was acquired from a reputable software vendor several years ago. This system contains numerous automated controls. The auditor tested those controls most recently in the 2010 audit. No changes have been made to any of these controls since testing and the client’s controls over IT security and software program changes are excellent.

10-41 (Objective 10-7) The following are independent situations for which you will recommend an appropriate audit report on internal control over financial reporting as required by PCAOB auditing standards:

Part 2 / THE AUDIT PROCESS

330

1. The auditor identified a material misstatement in the financial statements that was not detected by management of the company.

2. The auditor was unable to obtain any evidence about the operating effectiveness of internal control over financial reporting.

3. The auditor determined that a deficiency in internal control exists that will not prevent or detect a material misstatement in the financial statements.

4. During interim testing, the auditor identified and communicated to management a significant control deficiency. Management immediately corrected the deficiency and the auditor was able to sufficiently test the newly-instituted internal control before the end of the fiscal period.

5. As a result of performing tests of controls, the auditor identified a significant deficiency in internal control over financial reporting; however, the auditor does not believe that it represents a material weakness in internal control.

For each situation, state the appropriate audit report from the following alternatives: • Unqualified opinion on internal control over financial reporting

• Qualified or disclaimer of opinion on internal control over financial reporting

• Adverse opinion on internal control over financial reporting

Required

CASE

10-42 (Objective 10-5) The following is the description of sales and cash receipts for the Lady’s Fashion Fair, a retail store dealing in expensive women’s clothing. Sales are for cash or credit, using the store’s own billing rather than credit cards.

Each salesclerk has her own sales book with prenumbered, three-copy, multicolored sales slips attached, but perforated. Only a central cash register is used. It is operated by the store supervisor, who has been employed for 10 years by Alice Olson, the store owner. The cash register is at the store entrance to control theft of clothes.

Salesclerks prepare the sales invoices in triplicate. The original and the second copy are

given to the cashier. The third copy is retained by the salesclerk in the sales book. When the sale is for cash, the customer pays the salesclerk, who marks all three copies “paid” and presents the money to the cashier with the invoice copies.

All clothing is put into boxes or packages by the supervisor after comparing the clothing to the description on the invoice and the price on the sales tag. She also rechecks the clerk’s calculations. Any corrections are approved by the salesclerk. The clerk changes her sales book at that time.

A credit sale is approved by the supervisor from an approved credit list after the salesclerk prepares the three-part invoice. Next, the supervisor enters the sale in her cash register as a credit or cash sale. The second copy of the invoice, which has been validated by the cash register, is given to the customer.

At the end of the day, the supervisor recaps the sales and cash and compares the totals to the cash register tape. The supervisor deposits the cash at the end of each day in the bank’s deposit box. The cashier’s copies of the invoices are sent to the accounts receivable clerk along with a summary of the day’s receipts. The bank mails the deposit slip directly to the accounts receivable clerk.

Each clerk summarizes her sales each day on a daily summary form, which is used in part to calculate employees’ sales commissions. Marge, the accountant, who is prohibited from handling cash, receives the supervisor’s summary and the clerk’s daily summary form. Daily, she puts all sales invoice information into the firm’s computer, which provides a complete printout of all input and summaries. The accounting summary includes sales by salesclerk, cash sales, credit sales, and total sales. Marge compares this output with the supervisor’s and salesclerks’ summaries and reconciles all differences.

The computer updates accounts receivable, inventory, and general ledger master files. After the update procedure has been run on the computer, Marge’s assistant files all sales invoices by customer number. A list of the invoice numbers in numerical sequence is included in the sales printout.

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 331

 

Required

10-43 (Objective 10-5) In Parts I and II of this case, you performed preliminary analytical procedures and assessed acceptable audit risk and inherent risk for Pinnacle Manufacturing. Your team has been assigned the responsibility of auditing the acquisition and payment cycle and one related balance sheet account, accounts payable. The general approach to be taken will be to reduce assessed control risk to a low level, if possible, for the two main types of transactions affecting accounts payable: acquisitions and cash disbursements. The following are furnished as background information:

• A summary of key information from the audit of the acquisition and payment cycle and accounts payable in the prior year, which was extracted from the previous audit firm’s audit files (Figure 10-12)

• A flowchart description of the accounting system and internal controls for the acquisition and payment cycle (Figure 10-13, p. 334)—the flowchart shows that although each of the company’s three divisions has its own receiving department, the purchasing and accounts payable functions are centralized

The purpose of Part III is to obtain an understanding of internal control and assess control risk for Pinnacle Manufacturing’s acquisition and cash disbursement transactions.

a. Familiarize yourself with the internal control system for acquisitions and cash dis- bursements by studying the information in Figure 10-12 and Figure 10-13.

b. Prepare a control risk matrix for acquisitions and a separate one for cash disbursements using Figure 10-5 on page 309 as a guide. A formatted control risk matrix is provided on the textbook Web site. The objectives should be specific transaction-related audit objec- tives for acquisitions for the first matrix and cash disbursements for the second matrix.

Part 2 / THE AUDIT PROCESS

The mail is opened each morning by a secretary in the owner’s office. All correspon- dence and complaints are given to the owner. The secretary prepares a prelist of cash receipts. He totals the list, prepares a deposit slip, and deposits the cash daily. A copy of the prelist, the deposit slip, and all remittances returned with the cash receipts are given to Marge. She uses this list and the remittances to record cash receipts and update accounts receivable, again by computer. She reconciles the total receipts on the prelist to the deposit slip and to her printout. At the same time, she compares the deposit slip received from the bank for cash sales to the cash receipts journal.

A weekly aged trial balance of accounts receivable is automatically generated by the computer. A separate listing of all unpaid bills over 60 days is also automatically prepared. These are given to Mrs. Olson, who acts as her own credit collector. She also approves all write-offs of uncollectible items and forwards the list to Marge, who writes them off.

Each month Marge mails statements generated by the computer to customers. Complaints and disagreements from customers are directed to Mrs. Olson, who resolves them and informs Marge in writing of any write-downs or misstatements that require correction.

The computer system also automatically totals the journals and posts the totals to the general ledger. A general ledger trial balance is printed out, from which Marge prepares financial statements. Marge also prepares a monthly bank reconciliation and reconciles the general ledger to the aged accounts receivable trial balance.

Because of the importance of inventory control, Marge prints out the inventory perpetual totals monthly, on the last day of each month. Salesclerks count all inventory after store hours on the last day of each month for comparison with the perpetuals. An inventory shortages report is provided to Mrs. Olson. The perpetuals are adjusted by Marge after Mrs. Olson has approved the adjustments.

a . For each sales transaction-related audit objective, identify one or more existing controls. b. For each cash receipts transaction-related audit objective, identify one or more existing

Required

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART III

controls.

c. Identify deficiencies in internal control for sales and cash receipts.

332

FIGURE 10-12 Information for Audit of Accounts Payable — Previous Year

Accounts payable, 12-31-10

Number of accounts

Total accounts payable

Range of individual balances

Tolerable misstatement for accounts payable

452 $9,460,776 $33.27–$677,632.97 $230,000

Transactions, 2010 Acquisitions:

Number of acquisitions Total acquisitions

Cash disbursements: Number of disbursements Total cash disbursements

16,243 $92,883,712

23,661 $87,280,031

Results of audit procedures—tests of controls and substantive tests of transactions for acquisitions (sample size of 100):

Purchase order not approved 1 Purchase quantities, prices, and/or extensions not correct 1 Transactions charged to wrong general ledger account 2 Transactions recorded in wrong period 1 No other exceptions

Results of audit procedures—cash disbursements (sample size of 100):

Cash disbursement recorded in wrong period 2 No other exceptions

Results of audit procedures—accounts payable:

(50% of vendors’ balances were verified; combined net understatement amounts were projected to the population as follows):

Three cutoff misstatements

One difference in amounts due to disputes and discounts

No adjustment was necessary because the total projected misstatement

was not material.

$52,349 $9,552

See pages 608–612 in Chapter 18 for transaction-related audit objectives for acquisitions and cash disbursements. In doing Part III, the following steps are recommended:

(1) Controls

a. Identify key controls for acquisitions and for cash disbursements. After you decide on the key controls, include each control in one of the two matrices.

b. Include a “C” in the matrix in each column for the objective(s) to which each

control applies. Several of the controls should satisfy multiple objectives.

(2) Deficiencies

a. Identify key deficiencies for acquisitions and for cash disbursements. After you decide on the deficiencies, include each significant deficiency or material weak- ness in the bottom portion of one of the two matrices.

b. Include a “D” in the matrix in each column for the objective(s) to which each significant deficiency or material weakness applies.

(3) Assess control risk as high, medium, or low for each objective using your best judgment. Do this for both the acquisitions and cash disbursements matrices.

INTERNET PROBLEM 10-1: DISCLOSURE OF MATERIAL

WEAKNESSES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

Section 404(a) of the Sarbanes–Oxley Act requires management of a public company to issue a report on internal control over financial reporting (ICOFR) as of the end of the company’s fiscal year. Many companies have reported that their ICOFR was operating effectively, while others have reported that such controls were not effective in design or operation.

Chapter 10 / SECTION 404 AUDITS OF INTERNAL CONTROL AND CONTROL RISK 333

 

 

FIGURE 10-13

Pinnacle Manufacturing — Acquisition and Payment Cycle

CENTRALIZED PURCHASING DEPARTMENT

Purchase order

P.O. REQ

To vendor

RECEIVING DEPARTMENTS

Receiving report

R.R.

1

ACCOUNTS PAYABLE CLERK

INV

R.R.

P.O. REQ

CASH DISBURSEMENTS CLERK

Prepare purchase order from approved

requisition; P.O. approved by supervisor

Review document package for completeness, initial, and write date on invoice

Receive and check goods

Receive vendor’s invoice

Key enter and process cash disbursement transaction data

Cash Voucher disbursement document

transaction package file

2

Match documents Check prices Check extensions Compute discounts Prepare voucher

Print reports

Key enter and process purchase

transaction data

Notes on controls

• Chart of accounts—the company uses an

adequate detailed chart of accounts.

• Prenumbered documents—all documents

shown are prenumbered. They are accounted

Cash disbursements journal

Check

To vendor; signed by treasurer (reviews support)

for by a function other than the preparer.

Voucher

Purchase

• Bank reconciliation—done monthly by the transaction document

treasurer. file • Procedures are applied daily. Backlogs are

package*

Update accounts payable master file

resolved promptly by authorizing overtime. • Accounts payable master file total is

reconciled to the general ledger total monthly.

File description

1. Chronological 2. Numerical

Acquisitions journal

Accounts payable master file

Print reports

*Includes voucher, vendor’s invoice, receiving report, purchase order, and purchase requisition.

Required

1. Visit the SEC’s website (www.sec.gov) and search for the Form 10-K filing for Organic Alliance Inc. for fiscal year ended December 31, 2009.

2. Locate Management’s Annual Report on Internal Control Over Financial Reporting to answer the following questions:

a. Whoisresponsibleforestablishingandimplementingeffectiveinternalcontrols? b. What type of internal controls is the report addressing?

c. What framework did management use to evaluate its internal control?

d. What was management’s conclusion about the operating effectiveness of internal

control?

e. What information is provided to help readers understand why management

arrived at that conclusion?

f. Whatchanges,ifany,hasmanagementmadetoimproveinternalcontrols?

3. Locate the report of the independent registered public accounting firm. What information does the audit firm provide about its evaluation of internal controls over financial reporting?

Chapter 11

REVIEW QUESTIONS

11-1 (Objective 11-1) Define fraudulent financial reporting and give two examples that illustrate fraudulent financial reportinAg.pago   Enhancer 11-2 (Objective 11-1) Define misappropriation of assets and give two examples of mis- appropriation of assets.

11-3 (Objective 11-1) Distinguish fraudulent financial reporting from misappropriation of assets.

11-4 (Objective 11-2) What are the three conditions of fraud often referred to as “the fraud triangle?”

11-5 (Objective 11-2) Give examples of risk factors for fraudulent financial reporting for each of the three fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization. 11-6 (Objective 11-2) Give examples of risk factors for misappropriation of assets for each of the three fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization. 11-7 (Objective 11-3) What sources are used by the auditor to gather information to assess fraud risks?

11-8 (Objective 11-3) What should the audit team consider in its planning discussion about fraud risks?

11-9 (Objective 11-3) Auditors are required to make inquiries of individuals in the company when gathering information to assess fraud risk. Identify those with whom the auditor must make inquiries.

11-10 (Objective 11-4) Describe the purpose of corporate codes of conduct and identify three examples of items addressed in a typical code of conduct.

11-11 (Objective 11-4) 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.

11-12 (Objective 11-4) Distinguish management’s responsibility from the audit com- mittee’s responsibility for designing and implementing antifraud programs and controls within a company.

11-13 (Objective 11-5) What are the three categories of auditor responses to fraud risks?

Chapter 11 / FRAUD AUDITING 361

11-14 (Objective 11-5) What three auditor actions are required to address the potential for management override of controls?

11-15 (Objective 11-6) Describe the three main techniques used to manipulate revenue. 11-16 (Objective 11-6) 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?

11-17 (Objective 11-7) 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. 11-18 (Objective 11-7) Identify three verbal and three nonverbal cues that may be observed when making inquiries of an individual who is being deceitful.

11-19 (Objective 11-7) 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?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

11-20 (Objectives 11-2, 11-3) The following questions address fraud risk factors and the assessment of fraud risk.

a. Because of the risk of material misstatements due to fraud (fraud risk), an audit of financial statements in accordance with generally accepted auditing standards should be performed with an attitude of

(1) objective judgment. (3) professional skepticism.

(2) independent integrity. (4) impartial conservatism.

b. Which of the following circumstances is most likely to cause an auditor to consider whether material misstatements due to fraud exist in an entity’s financial statements? (1) Managementplaceslittleemphasisonmeetingearningsprojectionsofexternalparties.

 

(2) Theboardofdirectorsoverseesthefinancialreportingprocessandinternalcontrol.

(3) Significant deficiencies in internal control previously communicated to manage- ment have been corrected.

(4) Transactions selected for testing are not supported by proper documentation.

c. Which of the following characteristics is most likely to heighten an auditor’s concern about the risk of material misstatements due to fraud in an entity’s financial statements?

(1) The entity’s industry is experiencing declining customer demand.

(2) Employees who handle cash receipts are not bonded.

(3) Internal auditors have direct access to the board of directors and the entity’s management.

(4) Theboardofdirectorsisactiveinoverseeingtheentity’sfinancialreportingpolicies.

d. Which of the following circumstances is most likely to cause an auditor to increase the assessment of the risk of material misstatement of the financial statements due to fraud? (1) Property and equipment are usually sold at a loss before being fully depreciated. (2) Unusualdiscrepanciesexistbetweentheentity’srecordsandconfirmationreplies. (3) Monthly bank reconciliations usually include several in-transit items.

(4) Clerical errors are listed on a computer-generated exception report.

11-21 (Objective 11-5) The following questions concern the auditor’s responses to the possibility of fraud.

a. When fraud risk factors are identified during an audit the auditor’s documentation should include

Part 2 / THE AUDIT PROCESS

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

The Risk

Factors Identified

Yes Yes No No

The Auditor’s Response to

The Risk Factors Identified

Yes No Yes No

362

b. If an independent audit leading to an opinion on financial statements causes the auditor to believe that a material misstatement due to fraud exists, the auditor should first

(1) considertheimplicationsforotheraspectsoftheauditanddiscussthematterwith

the appropriate levels of management.

(2) maketheinvestigationnecessarytodeterminewhetherfraudhasactuallyoccurred.

(3) request that management investigate to determine whether fraud has actually

occurred.

(4) consider whether fraud was the result of a failure by employees to comply with

existing controls.

c. As a result of analytical procedures, the auditor determines that the gross profit per- centage has increased from 30 percent in the preceding year to 40 percent in the current year. The auditor should

(1) document management’s plans for maintaining this trend.

(2) evaluate management’s performance in causing the improvement in gross profit. (3) require footnote disclosure.

(4) increasetheauditor’sassessmentoftheriskofrevenuemisstatements,includingfraud.

11-22 (Objective 11-6) The following questions address fraud risks in specific audit areas and accounts.

a. Cash receipts from sales on account have been misappropriated. Which of the follow- ing acts will conceal this embezzlement and be least likely to be detected by the auditor? (1) Understating the sales journal.

(2) Overstating the accounts receivable control account.

(3) Overstating the accounts receivable subsidiary records. (4) Understating the cash receipts journal.

b. An auditor discovers that a client’s accounts receivable turnover is substantially lower for the current year than for the prior year. This trend may indicate that

(1) fictitious credit sales have been recorded during the year.

(2) employees have stolen inventory just before year-end.

(3) the client recently tightened its credit-granting policies. (4) an employee has been lapping receivables in both years.

c. Which of the following internal controls will best detect the theft of valuable items from an inventory that consists of hundreds of different items selling for $1 to $10 and a few items selling for hundreds of dollars?

(1) Maintain a perpetual inventory of only the more valuable items, with frequent

periodic verification of the validity of the perpetual inventory records.

(2) Have an independent auditing firm examine and report on management’s asser- tion about the design and operating effectiveness of the control activities relevant

to inventory.

(3) Have separate warehouse space for the more valuable items, with sequentially

numbered tags.

(4) Require an authorized officer’s signature on all requisitions for the more valuable

items.

DISCUSSION QUESTIONS AND PROBLEMS

11-23 (Objective 11-2) During audit planning, an auditor obtained the following information:

1. Management has a strong interest in employing inappropriate means to minimize reported earnings for tax-motivated reasons.

2. The company’s board of directors includes a majority of directors who are inde- pendent of management.

3. Assets and revenues are based on significant estimates that involve subjective judg- ments and uncertainties that are hard to corroborate.

4. The company is marginally able to meet exchange listing and debt covenant require- ments.

Chapter 11 / FRAUD AUDITING 363

 

Required

Required

5. New accounting pronouncements have resulted in explanatory paragraphs for consistency for the company and other firms in the industry.

6. The company has experienced low turnover in management and its internal audit function.

7. Significant operations are located and conducted across international borders in jurisdictions where differing business environments and cultures exist.

8. There are recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality.

9. The company’s financial performance is threatened by a high degree of competition and market saturation.

a. Indicate whether the information indicates an increased risk for fraud.

b. If the information indicates an increased risk of fraud, indicate which fraud condition (incentives/pressures, opportunities, or attitudes/rationalization) is indicated.

11-24 (Objectives 11-1, 11-2, 11-3) Assessing the risk of fraud in a financial statement audit is a difficult audit judgment. Auditing standards require the auditor to perform several audit procedures to accumulate information to assess the risk of fraud. You are the in-charge auditor responsible for planning the financial statement audit of Spencer, Inc. Two new staff auditors are assisting you with the initial audit planning and have asked you the following questions.

Briefly summarize your response to these staff auditor questions:

a. What is the purpose of the audit team’s brainstorming session?

b. Who should attend the brainstorming session and when should the session be held? c. What is the role of the two staff auditors in the brainstorming session?

d. What is the auditor’s responsibility under auditing standards for detecting fraud?

11-25 (Objectives 11-2, 11-6) The Art Appreciation Society operates a museum for the benefit and enjoyment of the community.

Required

collect a $5.00 admission fee from each nonmember patron. Members of the Art Appreciation Society are permitted to enter free of charge upon presentation of their membership cards.

At the end of each day, one of the clerks delivers the proceeds to the treasurer. The treasurer counts the cash in the presence of the clerk and places it in a safe. Each Friday afternoon, the treasurer and one of the clerks deliver all cash held in the safe to the bank and receive an authenticated deposit slip that provides the basis for the weekly entry in the accounting records.

The Art Appreciation Society board of directors has identified a need to improve its internal controls over cash admission fees. The board has determined that the cost of installing turnstiles, sales booths, or otherwise altering the physical layout of the museum will greatly exceed any benefits. However, the board has agreed that the sale of admission tickets must be an integral part of its improvement efforts.

Smith has been asked by the board of directors of the Art Appreciation Society to review the internal control over cash admission fees and provide suggestions for improvements.

a. Indicate deficiencies in the existing internal controls over cash admission fees that Smith should identify, and recommend one improvement for each of the deficiencies identified. Organize the answer as indicated in the following illustrative example.*

When the museum is open to the public, two clerks who are positioned at the entrance

Deficiencies

1. There is no basis for establishing the number of paying patrons.

Recommendation

1. Prenumbered admission tickets should be issued upon payment of the admission fee.

Part 2 / THE AUDIT PROCESS

b. Indicate which of the deficiencies, if any, increase the likelihood of misappropriation of assets.

c. Indicate which of the deficiencies, if any, increase the likelihood of fraudulent finan- cial reporting.

*AICPA adapted.

364

11-26 (Objectives 11-1, 11-4, 11-6) The following misstatements are included in the accounting records of the Joyce Manufacturing Company:

1. A shipment to a customer was not billed because of the loss of the bill of lading.

2. A sales invoice was miscalculated by $1,000 as a result of a key-entry mistake.

3. Cash paid on accounts receivable that had been prelisted by a secretary was stolen by

the bookkeeper who records cash receipts and accounts receivable. He failed to

record the transactions.

4. A material sale was recorded on the last day of the year even though the goods were

not shipped until 3 days later.

5. Merchandise was shipped to a customer, but no bill of lading was prepared. Because

billings are prepared from bills of lading, the customer was not billed.

6. A sale to a residential customer was unintentionally classified as a commercial sale.

7. The shipping clerk included several additional valuable items to a shipment that

were not included in the customer’s order and were not invoiced to the customer. The shipping clerk has an arrangement with the customer to share the proceeds from sales of the additional items shipped.

8. Cash paid on accounts receivable was stolen by the mail clerk when the mail was opened.

a. Identify whether each misstatement is an error or fraud.

b. For each misstatement, list one or more controls that should have prevented it from occurring on a continuing basis.

c. For each misstatement, identify evidence the auditor can use to uncover it.

11-27 (Objectives 11-2, 11-4, 11-6) Appliances Repair and Service Company bills all

customers rather than collecting in cash when services are provided. All mail is opened by

Tom Gyders, treasurer. Gyders, a CPA, is the most qualified person in the company who is in

the office daily. Therefore, he can solve problems and respond to customers’ needs quickly.

Upon receipt of cash, he immediately prepares a listing of the cash and a duplicate deposit

Required

slip. Cash is deposited daily. Gyders uses the listing to enter the financial transactions in the

computerized accounting records. He also contacts customers about uncollected accounts receivable. Because he is so knowledgeable about the business and each customer, he grants credit, authorizes all sales allowances, and charges off uncollectible accounts. The owner is extremely pleased with the efficiency of the company. He can run the business without spending much time there because of Gyders’ effectiveness.

Imagine the owner’s surprise when he discovers that Gyders has committed a major theft of the company’s cash receipts. He did so by not recording sales, recording improper credits to recorded accounts receivable, and overstating receivables.

a. Given that cash was prelisted, went only to the treasurer, and was deposited daily, what internal control deficiency permitted the fraud?

b. What are the benefits of a prelisting of cash? Who should prepare the prelisting and what duties should that person not perform?

c. Assume that an appropriate person, as discussed in part b, prepares a prelisting of cash. What is to prevent that person from taking the cash after it is prelisted but before it is deposited?

d. Who should deposit the cash, given your answer to part b?

11-28 (Objectives 11-2, 11-4, 11-6) The Kowal Manufacturing Company employs about 50 production workers and has the following payroll procedures.

The factory foreman interviews applicants and on the basis of the interview either hires or rejects them. When applicants are hired, they prepare a W-4 form (Employee’s Withholding Exemption Certificate) and give it to the foreman. The foreman writes the hourly rate of pay for the new employee in the corner of the W-4 form and then gives the form to a payroll clerk as notice that the worker has been employed. The foreman verbally advises the payroll department of rate adjustments.

A supply of blank time cards is kept in a box near the time clock at the entrance to the factory. Each worker takes a time card on Monday morning, fills in his or her name, and

Required

Chapter 11 / FRAUD AUDITING 365

 

Required

punches the time clock upon their daily arrival and departure. At the end of the week, the workers drop the time cards in a box near the door to the factory.

On Monday morning, the completed time cards are taken from the box by a payroll clerk. One of the payroll clerks then enters the payroll transactions into the computer, which records all information for the payroll journal that was calculated by the clerk and automatically updates the employees’ earnings records and general ledger. Employees are automatically removed from the payroll when they fail to turn in a time card.

The payroll checks that are not directly deposited into employees’ bank accounts are manually signed by the chief accountant and given to the foreman. The foreman distributes the checks to the workers in the factory and arranges for the delivery of the checks to the workers who are absent. The payroll bank account is reconciled by the chief accountant, who also prepares the various quarterly and annual payroll tax reports.

a. List the most important deficiency in internal control and state the misstatements that are likely to result from the deficiency.

b. For each deficiency that increases the likelihood of fraud, identify whether the likely fraud is misappropriation of assets or fraudulent financial reporting.*

11-29 (Objectives 11-2, 11-3, 11-4, 11-6) Each year near the balance sheet date, when the president of Bargon Construction, Inc. takes a 3-week vacation to Hawaii, she signs several checks to pay major bills during the period she is absent. Jack Morgan, head bookkeeper for the company, uses this practice to his advantage. Morgan makes out a check to himself for the amount of a large vendor’s invoice, and because there is no acquisitions journal, he records the amount in the cash disbursements journal as an acquisition from the supplier listed on the invoice. He holds the check until several weeks into the subsequent period to make sure that the auditors do not get an opportunity to examine an electronic copy of the cancelled check. Shortly after the first of the year when the president returns, Morgan resubmits the invoice for payment and again records the check in the cash disbursements journal. At that point, he marks the invoice “paid” and files it with all other paid invoices.

Required

that he has developed a foolproof method.

a. What is the auditor’s responsibility for discovering this type of embezzlement? b. What deficiencies exist in the client’s internal control?

c. What evidence can the auditor use to uncover the fraud?

11-30 (Objective 11-1) The following are activities that occurred at Franklin Manufacturing, a nonpublic company.

1. Franklin’s accountant did not record checks written in the last few days of the year until the next accounting period to avoid a negative cash balance in the financial statements. 2. Franklin’s controller prepared and mailed a check to a vendor for a carload of material that was not received. The vendor’s chief accountant, who is a friend of Franklin’s controller, mailed a vendor’s invoice to Franklin, and the controller prepared a receiving report. The vendor’s chief accountant deposited the check in an account he

had set up with a name almost identical to the vendor’s.

3. The accountant recorded cash received in the first few days of the next accounting

period in the current accounting period to avoid a negative cash balance.

4. Discounts on checks to Franklin’s largest vendor are never taken, even though the bills are paid before the discount period expires. The president of the vendor’s company provides free use of his ski lodge to the accountant who processes the checks

in exchange for the lost discounts.

5. Franklin shipped and billed goods to a customer in New York on December 23, and

the sale was recorded on December 24, with the understanding that the goods will be

returned on January 31 for a full refund plus a 5 percent handling fee.

6. Franklin’s factory superintendent routinely takes scrap metal home in his pickup

and sells it to a scrap dealer to make a few extra dollars.

*AICPA adapted.

Part 2 / THE AUDIT PROCESS

Morgan has been following this practice successfully for several years and feels confident

366

7. Franklin’s management decided not to include a footnote about a material uninsured lawsuit against the company on the grounds that the primary user of the statements, a small local bank, will probably not understand the footnote anyway.

a. Identify which of these activities are frauds.

b. For each fraud, state whether it is a misappropriation of assets or fraudulent financial reporting.

11-31 (Objectives 11-5, 11-6) The following are various potential frauds in the sales and collection cycle:

1. The company engaged in channel stuffing by shipping goods to customers that had not been ordered.

2. The allowance for doubtful accounts was understated because the company altered the aging of accounts receivable to reduce the number of days outstanding for delinquent receivables.

3. A cashier stole cash receipts that had been recorded in the cash register.

4. The company recorded “bill-and-hold sales” at year-end. Although the invoices were recorded as sales before year-end, the goods were stored in the warehouse and shipped

after year-end.

5. The company did not record credit memos for returns received in the last month of

the year. The goods received were counted as part of the company’s year-end physical

inventory procedures.

6. The accounts receivable clerk stole checks received in the mail and deposited them in

an account that he controlled. He issued credit memos to the customers in the amount

of the diverted cash receipts.

7. The company contacted a major customer and asked them to accept a major ship-

ment of goods before year end. The customer was told that they could return the

Required

goods without penalty if they were unable to sell the goods.

8. A cashier stole cash receipts by failing to record the sales in the cash register.

Required

a. Indicate whether the fraud involves misappropriation of assets or fraudulent financial reporting.

b. For those frauds that involve misappropriation of assets, state a control that would be effective in preventing or detecting the misappropriation.

c. For those frauds that involve fraudulent financial reporting, state an audit procedure that would be effective in detecting the fraud.

11-32 (Objectives 11-6, 11-7) The following audit procedures are included in the audit program because of heightened risks of material misstatements due to fraud.

1. Use audit software to search cash disbursement master files for missing check numbers. 2. Search the accounts receivable master file for account balances with missing or

unusual customer numbers (e.g., “99999”).

3. Engage an actuarial specialist to examine management’s assumptions about average

length of employment and average life expectancy of retirees used in pension account-

ing decisions.

4. Send confirmations to customers for large sales transactions made in the fourth quarter

of the year to obtain customer responses about terms related to the transfer of title

and ability to return merchandise.

5. Use audit software to search purchase transactions to identify any with non-standard

vendor numbers or with vendor names reflecting related parties.

6. Search sales databases for missing bill of lading numbers.

For each audit procedure:

a. Describe the type of fraud risk that is likely associated with the need for this audit procedure.

b. Identify the related accounts likely affected by the potential fraud misstatement.

c. Identify the related audit objective(s) that this procedure addresses.

Required

Chapter 11 / FRAUD AUDITING 367

 

CASE

Required

Kent: That’s nothing new. Brown was like that years ago. Brown caused frequent disputes with Jones, CPA, the predecessor auditor. Three years ago, Jones told Brown how ineffective the internal audit department was then. Next thing you know, Jones is out and I’m in. Why bother? I’m just as happy that those understaffed internal auditors don’t get in our way. Just remember, the bottom line is . . . are the financial statements fairly presented? And they always have been. We don’t provide any assurances about fraud. That’s management’s job.

Smith: But what about the lack of segregation of duties in the cash disbursements depart- ment? That clerk could write a check for anything.

Kent: Sure. That’s a material weakness every year and probably will be again this year. But we’re talking cost-effectiveness here, not fraud. We just have to do lots of testing on cash disbursements and report it again.

Smith: What about the big layoffs coming up next month? It’s more than a rumor. Even the employees know it’s going to happen, and they’re real uptight about it.

Kent: I know, it’s the worst kept secret at SCS, but we don’t have to consider that now. Even if it happens, it will only improve next year’s financial results. Brown should have let these people go years ago. Let’s face it, how else can Mint even come close to the 30 percent earnings increase next year?

a. Describe the fraud risk factors that are indicated in the dialogue above.

b. Describe Kent’s misconceptions regarding the consideration of fraud in the audit of SCS’s financial statements that are contained in the preceding dialogue, and explain

why each is a misconception.

c. Describe an auditor’s audit documentation requirements regarding the assessment of

the risk of material misstatement due to fraud.

†Copyright 1998, 2003 by the American Institute of Certified Public Accountants, Inc. Reprinted with permission.

Part 2 / THE AUDIT PROCESS

11-33 (Objectives 11-2, 11-3, 11-4) Kent, CPA, is the engagement partner on the financial statement audit of Super Computer Services Co. (SCS) for the year ended April 30, 2011. On May 6, 2011, Smith, the senior auditor assigned to the engagement, had the following conversation with Kent concerning the planning phase of the audit:†

Kent: Do you have all the audit programs updated yet for the SCS engagement?

Smith: Mostly. I still have work to do on the fraud risk assessment.

Kent: Why? Our “errors and irregularities” program from last year is still OK. It has passed peer review several times. Besides, we don’t have specific duties regarding fraud. If we find it, we’ll deal with it then.

Smith: I don’t think so. That new CEO, Mint, has almost no salary, mostly bonuses and stock options. Doesn’t that concern you?

Kent: No. Mint’s employment contract was approved by the Board of Directors just three months ago. It was passed unanimously.

Smith: I guess so, but Mint told those stock analysts that SCS’s earnings would increase 30 percent next year. Can Mint deliver numbers like that?

Kent: Who knows? We’re auditing the 2011 financial statements, not 2012. Mint will probably amend that forecast every month between now and next May.

Smith: Sure, but all this may change our other audit programs.

Kent: No, it won’t. The programs are fine as is. If you find fraud in any of your tests, just let me know. Maybe we’ll have to extend the tests. Or maybe we’ll just report it to the audit committee.

Smith: What would they do? Green is the audit committee’s chair, and remember, Green hired

Mint. They’ve been best friends for years. Besides, Mint is calling all the shots now. Brown,

the old CEO, is still on the Board, but Brown’s never around. Brown’s even been skipping

the Board meetings. Nobody in management or on the Board would stand up to Mint.

368

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART IV

11-34 (Objectives 11-2, 11-3) In Parts I (pp. 245–247) and II (pp. 287–288) of this case you performed preliminary analytical procedures and assessed acceptable audit risk and inherent risk for Pinnacle Manufacturing. In Part III (pp. 332–333) of the case, you obtained an understanding of internal control and assessed control risk for acquisition and cash disbursement transactions.

The auditor also assesses fraud risk as part of risk assessment procedures performed during audit planning. You have been invited by the audit partner on the Pinnacle engagement to participate in the fraud brainstorming session conducted as part of audit planning. The purpose of Part IV is to identify fraud risks and the response to these fraud risks in the audit of Pinnacle Manufacturing.

a. Use the fraud triangle and information from Parts I through III of this case to identify Required incentives/pressures, opportunities, and attitudes/rationalizations for Pinnacle to

engage in fraudulent financial reporting.

b. Identify one or more fraud risks that you believe exist due to the nature of Pinnacle’s industry. Indicate the accounts most likely to be affected by the identified fraud risks.

c. Auditors must generally identify a fraud risk for revenue recognition. Indicate at least two ways that Pinnacle might engage in revenue recognition fraud. Identify the specific nature of the potential fraud, and an audit procedure that you would perform to determine whether fraud is occurring.

d. In Part I of this case you performed preliminary analytical procedures on Pinnacle’s financial statements. Identify changes in account balances or ratios that you believe indicate the potential for fraud, and describe the nature of the potential fraud.

e. Part II of the case includes 11 situations that you encountered in audit planning. For

each situation, describe whether it indicates a potential fraud risk. For each potential fraud risk, identify the related fraud risk triangle element(s).

ACL PROBLEM

11-35 (Objective 11-6) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material preceding the instructions about “Quick Sort” before locating the appropriate command to answer questions a-f. For this problem use the Metaphor_APTrans_2002 file in ACL_Demo. The suggested command or other source of information needed to solve the problem requirement is included at the end of each question.

a. b. c.

d. e .

f .

Total the Invoice Amount column for comparison to the general ledger. (Total Field)

Recalculate unit cost times quantity and identify any extension misstatements. (Filter)

Products that Metaphor purchases should not exceed $100 per unit. Print any pur- chases for subsequent follow-up where unit cost exceeded that amount. (Filter)

Identify the three vendors from which the largest total dollar accounts payable transactions occurred in 2002. (Summarize and Quick Sort)

For each of the three vendors in question d, list any transactions that exceeded $15,000 for subsequent follow-up. Include the vendor number, invoice number, and invoice amount. (Filter)

Vendor numbers 10134 and 13440 are related parties to Metaphor. Print any accounts payable transactions with those two vendors. (Filter) Also, determine the total amount of transactions with vendor 10134. (Total Field)

Chapter 11 / FRAUD AUDITING 369

 

INTERNET PROBLEM 11-1: BRAINSTORMING ABOUT FRAUD RISKS

Required

SAS No. 99 requires auditors to conduct a brainstorming session to discuss the potential for fraud and how the auditor might respond to the risk of fraud. However, the standard provides limited guidance on how this brainstorming session should take place. Read “A Primer for Brainstorming Fraud Risks” by Mark Beasley and Greg Jenkins in the December 2003 issue of Journal of Accountancy (www.journalofaccountancy.com/Issues/2003/Dec/ APrimerForBrainstormingFraudRisks.htm.) to answer the following questions.

a. What are three common pitfalls that should be avoided during brainstorming sessions? How can these problems be avoided?

b. What are three important techniques to improve the effectiveness of a brainstorming session?

Chapter 12

REVIEW QUESTIONS

12-1 (Objective 12-1) Explain how client internal controls can be improved through the proper installation of IT.

12-2 (Objective 12-2) Identify risks for accounting systems that rely heavily on IT functions. 12-3 (Objective 12-2) Define what is meant by an audit trail and explain how it can be

affected by the client’s integration of IT.

12-4 (Objective 12-2) Distinguish between random error resulting from manual proces- sing and systematic error resulting from IT processing and give an example of each cate- gory of error.

12-5 (Objective 12-2) Identify the traditionally segregated duties in noncomplex IT systems and explain how increases in the complexity of the IT function affect that separation.

12-6 (Objective 12-3) Distinguish between general controls and application controls and give two examples of each.

12-7 (Objective 12-3) Identify the typical duties within an IT function and describe how those duties should be segregated among IT personnel.

12-8 (Objective 12-4) 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.

12-9 (Objective 12-4) Explain the relationship between application controls and trans- action-related audit objectives.

12-10 (Objective 12-4) 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.

12-11 (Objective 12-5) 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.

12-12 (Objective 12-6) Describe risks that are associated with purchasing software to be installed on desktop computer hard drives. What precautions can clients take to reduce those risks?

12-13 (Objective 12-6) Compare the risks associated with network systems to those associated with centralized IT functions.

12-14 (Objective 12-6) How does the use of a database management system affect risks?

12-15 (Objective 12-6) 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.

12-16 (Objective 12-6) Your client has outsourced the majority of the accounting information system to a third-party data center. What impact would that have on your audit of the financial statements?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

12-17 (Objectives 12-1, 12-4) The following questions concern the characteristics of IT systems. Choose the best response.

a. Effective management of information technologies in an organization embraces the viewpoint that

(1) most technologies reduce existing risk conditions.

Part 2 / THE AUDIT PROCESS

(2) technologies reduce some types of risks while introducing new types of risks to be managed.

(3) technologies generally increase an organization’s overall net risks.

(4) the objective of technology implementations is to increase profitability on a net

basis.

b. Which of the following is generally not considered a category of IT general controls?

(1) Controls that determine whether a vendor number matches the pre-approved

vendors in the vendor master file.

(2) Controls that restrict system-wide access to programs and data.

(3) Controls that oversee the acquisition of application software.

(4) Controls that oversee the day-to-day operation of IT applications.

c. As general IT controls weaken, the auditor is most likely to

(1) reduce testing of automated application controls done by the computer.

(2) increase testing of general IT controls to conclude whether they are operating

effectively.

(3) expand testing of automated application controls used to reduce control risk to

cover greater portions of the fiscal year under audit.

(4) ignore obtaining knowledge about the design of general IT controls and whether

they have been implemented.

d. Which of the following is an example of an application control?

(1) The client uses access security software to limit access to each of the accounting

applications.

(2) EmployeesareassignedauserIDandpasswordthatmustbechangedeveryquarter.

(3) Thesalessystemautomaticallycomputesthetotalsaleamountandpoststhetotal

to the sales journal master file.

(4) Systems programmers are restricted from doing applications programming

systems. Choose the best response.

a. Which of the following client IT systems generally can be audited without examining or directly testing the computer programs of the system?

(1) A system that performs relatively uncomplicated processes and produces detailed

output.

(2) A system that affects a number of essential master files and produces limited

output.

(3) Asystemthatupdatesafewessentialmasterfilesandproducesnoprintedoutput

other than final balances.

(4) A system that does relatively complicated processing and produces little detailed

output.

b. Your client’s sales application ensures that all credit sales transactions in the sales journal have an assigned bill of lading number; however, the system does not ensure that all bill of lading numbers have an assigned sales invoice number. Your company may have a control deficiency related to the

(1) occurrence of sales transactions. (3) completeness of sales transactions. (2) accuracy of sales transactions. (4) completeness of the cash balance.

c. Before processing, the system validates the sequence of items to identify any breaks in sequence of input documents. This automated control is primarily designed to ensure the (1) accuracy of input. (3) completeness of input.

(2) authorization of data entry. (4) restriction of duplicate entries.

d. An auditor will use the test data approach to obtain certain assurances with respect to the (1) input data.

(2) machine capacity.

(3) procedures contained within the program.

functions.

12-18 (Objectives 12-2, 12-4) The following questions concern auditing complex IT

(4) degree of data entry accuracy.

Chapter 12 / THE IMPACT OF INFORMATION TECHNOLOGY 393

 

394

DISCUSSION QUESTIONS AND PROBLEMS

Required

12-19 (Objectives 12-2, 12-3) The following are misstatements that can occur in the sales and collection cycle:

1. A customer number on a sales invoice was transposed and, as a result, charged to the wrong customer. By the time the error was found, the original customer was no longer in business.

2. A former computer operator, who is now a programmer, entered information for a fictitious sales return and ran it through the computer system at night. When the money came in, he took it and deposited it in his own account.

3. A nonexistent part number was included in the description of goods on a shipping document. Therefore, no charge was made for those goods.

4. A customer order was filled and shipped to a former customer that had already filed for bankruptcy.

5. The sales manager approved the price of goods ordered by a customer, but he wrote down the wrong price.

6. A computer operator picked up a computer-based data file for sales of the wrong week and processed them through the system a second time.

7. For a sale, a data entry operator erroneously failed to enter the information for the salesman’s department. As a result, the salesman received no commission for that sale.

8. Several remittance advices were batched together for inputting. The cash receipts clerk stopped for coffee, set them on a box, and failed to deliver them to the data

input personnel.

a. Identify the transaction-related audit objective(s) to which the misstatement pertains. b. Identify one automated control that would have likely prevented each misstatement.

Required

IT system that separates the responsibilities of the computer operator, systems analyst, librarian, programmer, and data control group by having a different person do each function. Now, a budget reduction is necessary and one of the five people must be laid off. You are requested to give the college advice as to how the five functions could be done with reduced personnel and minimal negative effects on internal control. The amount of time the functions take is not relevant because all five people also do nonaccounting functions.

a. Divide the five functions among four people in such a way as to maintain the best possible control system.

b. Assume that economic times become worse for Phelps College and it must terminate employment of another person. Divide the five functions among three people in such a way as to maintain the best possible internal control. Again, the amount of time each function takes should not be a consideration in your decision.

c. Assume that economic times become so severe for Phelps College that only two people can be employed to do IT functions. Divide the five functions between two people in such a way as to maintain the best possible control system.

d. If the five functions were done by one person, will internal controls be so inadequate that an audit cannot be done? Discuss.

12-21 (Objectives 12-2, 12-3, 12-4, 12-5) The Meyers Pharmaceutical Company has the following system for billing and recording accounts receivable:

1. An incoming customer’s purchase order is received in the order department by a clerk who prepares a prenumbered company sales order on which the pertinent information, such as the customer’s name and address, customer’s account number, and items and quantities ordered, is inserted. After the sales order has been prepared, the customer’s purchase order is stapled to it.

2. The sales order is then passed to the credit department for credit approval. Rough approximations of the billing values of the orders are made in the credit department

Part 2 / THE AUDIT PROCESS

12-20 (Objectives 12-2, 12-3) You are doing the audit of Phelps College, a private school with approximately 2,500 students. With your firm’s consultation, they have instituted an

for those accounts on which credit limitations are imposed. After investigation,

approval of credit is noted on the sales order.

3. Next the sales order is passed to the billing department, where a clerk key-enters the

sales order information onto a data file, including unit sales prices obtained from an approved price list. The data file is used to prepare sales invoices.

The billing application automatically accumulates daily totals of customer account numbers and invoice amounts to provide “hash” totals and control amounts. These totals, which are inserted in a daily record book, serve as predetermined batch totals for verification of computer inputs. The billing is done on prenumbered, continuous, multi-copy forms that have the following designations:

(a) Customercopy

(b) Sales department copy, for information purposes

(c) Filecopy

(d) Shipping department copy, which serves as a shipping order

Bills of lading are also prepared as by-products of the invoicing procedure.

4. The shipping department copy of the invoice and the bills of lading are then sent to the shipping department. After the order has been shipped, copies of the bill of lading are returned to the billing department. The shipping department copy of the

invoice is filed in the shipping department.

5. In the billing department, one copy of the bill of lading is attached to the customer’s

copy of the invoice and both are mailed to the customer. The other copy of the bill of lading, together with the sales order is then stapled to the invoice file copy and filed in invoice numerical order.

6. The data file is updated for shipments that are different from those billed earlier. After these changes are made, the file is used to prepare a sales journal in sales invoice order and to update the accounts receivable master file. Daily totals are printed to match the control totals prepared earlier. These totals are compared with the “hash” and control totals by an independent person.

a. Identify the important controls and related sales transaction-related audit objectives.

Required

b. List the procedures that a CPA will use in an audit of sales transactions to test the identified controls and the substantive aspects of the sales transactions.

12-22 (Objective 12-3) During your audit of Wilcoxon Sports, Inc., a retail chain of stores, you learn that a programmer made an unauthorized change to the sales application program even though no work on that application had been approved by IT management. In order for the sales application program to work, the programmer had to make modifi- cations to the operating software security features. The unauthorized change forced the sales program to calculate an automatic discount for a customer who happens to be the brother-in-law of the programmer. The customer and programmer split the savings from the unauthorized discount. The programmer modified the program and returned it to the librarian who placed it into the files for live production use. No other information was forwarded to the librarian.

1. What recommendation do you have for management of Wilcoxon Sports, Inc. to prevent this from recurring?

2. Explain why you believe the suggested internal control improvements will prevent problems in the future.

12-23 (Objectives 12-1, 12-2, 12-3, 12-4, 12-5) You are conducting an audit of sales for the James Department Store, a retail chain store with a computer-based sales system in which computer-based cash registers are integrated directly with accounts receivable, sales, perpetual inventory records, and sales commission expense. At the time of sale, the salesclerks key-enter the following information directly into the cash register:

Required

• Product number

• Quantity sold

• Unit selling price

• Store code number

• Salesclerk number

• Date of sale

• Cash sale or credit sale

• Customer account number for all credit sales

Chapter 12 / THE IMPACT OF INFORMATION TECHNOLOGY 395

 

Required

The total amount of the sale, including sales tax, is automatically computed by the system and indicated on the cash register’s visual display. The only printed information for cash sales is the cash register receipt, which is given to the customer. For credit sales, a credit slip is prepared and one copy is retained by the clerk and submitted daily to the accounting department.

A summary of sales is printed out daily in the accounting department. The summary includes daily and monthly totals by salesclerks for each store as well as totals for each of 93 categories of merchandise by store. Perpetual inventory and accounts receivable records are updated daily on magnetic tape, but supporting records are limited primarily to machine- readable records.

a. What major problems does the auditor face in verifying sales and accounts receivable?

b. How can the concept of test data be used in the audit? Explain the difficulties the auditor will have to overcome in using test data.

c. How can generalized audit software be used in this audit? List several tests that can be conducted by using this approach.

d. The client would also like to reduce the time it takes to key-enter the information into the cash register. Suggest several ways in which this can be accomplished, considering the information now being key-entered manually.

12-24 (Objective 12-5) A CPA’s client, Boos & Baumkirchner, Inc., is a medium-size manufacturer of products for the leisure-time activities market (camping equipment, scuba gear, bows and arrows, and so forth). During the past year, a computer system was installed and inventory records of finished goods and parts were converted to computer processing. The inventory master file is maintained on a disk. Each record of the file contains the following information:

Required

Part 2 / THE AUDIT PROCESS

• Item or part number

• Description

• Size

• Total value of inventory on hand at cost • Date of last sale or usage

• Quantity used or sold this year

• Quantity on hand • Code number of major vendor

• Cost per unit • Code number of secondary vendor

In preparation for year-end inventory, the client has two identical sets of preprinted inventory count cards. One set is for the client’s inventory counts, and the other is for the CPA’s use to make audit test counts. The following information is on each card:

• Item or part number • Size

• Description • Unit-of-measure code

In taking the year-end inventory, the client’s personnel will write the actual counted quantity on the face of each card. When all counts are complete, the counted quantity will be entered into the system. The cards will be processed against the inventory database, and quantity-on-hand figures will be adjusted to reflect the actual count. A computer- generated edit listing will be prepared to show any missing inventory count cards and all quantity adjustments of more than $100 in value. These items will be investigated by client personnel, and all required adjustments will be made. When adjustments have been completed, the final year-end balances will be computed and posted to the general ledger.

The CPA has available generalized audit software that will run on the client’s computer and can process both card and disk files.

a. In general and without regard to the facts in this case, discuss the nature of generalized audit software and list the various types and uses.

b. List and describe at least five ways generalized audit software can be used to assist in all aspects of the audit of the inventory of Boos & Baumkirchner, Inc. (For example, the software can be used to read the disk inventory master file and list items and parts with a high unit cost or total value. Such items can be included in the test counts to increase the dollar coverage of the audit verification.)*

*AICPA adapted.

• Unit-of-measure code • Economic order quantity

396

12-25 (Objectives 12-2, 12-3) One of the firm’s audit partners, Alice Goodwin, just had lunch with a good friend, Sara Hitchcock, who is president of Granger Container Corporation. Granger Container Corp. is a fast-growing company that has been in business for only a few years. During lunch, Sara asked Alice for some advice and direction on how Granger Container should structure its systems development process within the Information Systems Department. Sara noted that because Granger has experienced such tremendous growth, the systems development process has evolved into its current state without much direction. Given Granger Container’s current size, Sara questions whether their current processes are reasonable. Sara’s concern is magnified by the fact that she has little under- standing of information systems processes. Alice told Sara about your information systems evaluation experience and agreed to have you look at Granger Container’s current systems development procedures. Sara gave Alice the following summary of the current processes:

Eric Winecoff is the information systems manager at Granger Container and has been at the company for 3 years. Before becoming an employee, Eric provided software consulting services for Granger Container. Granger Container purchased a basic software package from Eric’s former employer. Granger Container has the capability to make extensive modifications to the purchased software to adapt the software to Granger Container’s specific business needs.

Program change requests are initiated by either the operations staff (two employees) or the programming staff (two employees), depending on the nature of the change. All change requests are discussed in Eric’s office with the initiating staff. Based on that discussion, Eric provides a verbal approval or denial of the requested change. For approved projects, he encourages the programmers to visit with him from time to time to discuss progress on the projects. Eric’s long and varied experience with this particu- lar software is helpful in the evaluation of work done, and he is able to make substan- tive suggestions for improvement. Eric has complete faith in his programmers. He believes that if he controlled their activities too carefully, he would stifle their creativity.

Upon completion of the technical programming, Eric reviews the programs and related systems flowcharts. EricAopnlyargareoly idPenDtifFies laEst-nmhinuatenchcanegers before granting his final approval for implementation. One evening a week is set aside in the computer room for program debugging and testing.

The programmers stay late on those evenings so that they can load the programs themselves. To speed up the coding, debugging, and testing process, the programmers work with the actual production program. As a safeguard, however, testing is done on copies of the data files. The original data files are locked carefully in the file storage room. Eric is the only person who has access to the room.

When program changes are tested to the satisfaction of the programmers, Eric reviews the test results. If he approves the test results, he personally takes care of all the necessary communications and documentation. This involves preparing a short narrative description of the change, usually no longer than a paragraph. A copy of the narrative is sent to the user. Another copy is filed with the systems documentation. When the narrative is complete, Eric instructs operations to resume normal pro- duction with the new program.

a. Describe controls in Granger Container’s systems development and program change Required processes.

b. Describe deficiencies in Granger Container’s systems development and program change processes.

c. Provide recommendations for how Granger Container could improve its processes.

12-26 (Objective 12-4) Following are 10 key internal controls in the payroll cycle for Gilman Stores, Inc.

Key Controls

1. To input hours worked, payroll accounting personnel input the employee’s Social Security number. The system does not allow input of hours worked for invalid employee numbers.

Chapter 12 / THE IMPACT OF INFORMATION TECHNOLOGY 397

 

Required

2. The payroll application is programmed so that only human resource personnel are able to add employee names to the employee master files.

3. Input menus distinguish executive payroll, administrative payroll, and factory payroll.

4. The system automatically computes pay at time and a half once hours worked exceed 80 in a 2-week pay period.

5. The system accumulates totals each pay period of employee checks processed and debits the payroll expense general ledger account for the total amount.

6. Each pay period, payroll accounting clerks count the number of time cards sub- mitted by department heads for processing and compare that total with the number of checks printed by the system to ensure that each time card has a check.

7. For factory personnel, the payroll system matches employee ID numbers with ID numbers listed on job costing tickets as direct labor per the cost accounting system. The purpose of the reconciliation is to verify that the amount paid to each employee matches the amount charged to production during the time period.

8. The system generates a listing by employee name of checks processed. Department heads review these listings to ensure that each employee actually worked during the pay period.

9. On a test basis, payroll accounting personnel obtain a listing of pay rates and with- holding information for a sample of employees from human resources to recalculate gross and net pay.

10. The system automatically rejects processing an employee’s pay if inputted hours exceed 160 hours for a 2-week pay period.

For each control:

a. Identify whether the control is an automated application control (AC) or a manual control done by Gilman employees (MC).

b. Identify the transaction-related audit objective that is affected by the control.

Part 2 / THE AUDIT PROCESS

c. Identify which controls, if tested within the last two prior year audits, would not have

to be retested in the current year, assuming there are effective IT general controls and no changes to the noted control have been made since auditor testing was completed.

12-27 (Objectives 12-2, 12-3) Your new audit client, Hardwood Lumber Company, has a computerized accounting system for all financial statement cycles. During planning, you visited with the information systems vice president and learned that personnel in informa- tion systems are assigned to one of four departments: systems programming, applications programming, operations, or data control. Job tasks are specific to the individual and no responsibilities overlap with other departments. Hardwood Lumber relies on the operating system software to restrict online access to individuals. The operating system allows an employee with “READ” capabilities to only view the contents of the program or file. “CHANGE” allows the employee to update the contents of the program or file. “RUN” allows the employee to use a program to process data. Programmers, both systems and applications, are restricted to a READ-only access to all live application software program files but have READ and CHANGE capabilities for test copies of those software program files. Operators have READ and RUN capabilities for live application programs. Data control clerks have CHANGE access to data files only and no access to software program files. The person in charge of operations maintains access to the operating software security features and is responsible for assigning access rights to individuals. The computer room is locked and requires a card-key to access the room. Only operations staff have a card-key to access the room, and security cameras monitor access. A TV screen is in the information systems vice president’s office to allow periodic monitoring of access. The TV presents the live picture and no tape record is maintained. The librarian, who is in the operations department, is respon- sible for maintaining the library of program tapes and files. The librarian has READ and CHANGE access rights to program tapes and files. The files, when not being used, are stored in shelves located in a room adjacent to the computer room. They are filed numerically based on the tape label physically attached on the outside of the tape cartridge to allow for easy identification by operators as they access tapes from the shelves for processing.

398

What recommendations for change can you suggest to improve Hardwood’s information systems function?

12-28 (Objective 12-6) Parts for Wheels, Inc. has historically sold auto parts directly to consumers through its retail stores. Due to competitive pressure, Parts for Wheels installed an Internet-based sales system that allows customers to place orders through the company’s Web site. The company hired an outside Web site design consultant to create the sales system because the company’s IT personnel lack the necessary experience.

Customers use the link to the inventory parts listing on the Web site to view product descriptions and prices. The inventory parts listing is updated weekly. To get the system online quickly, management decided not to link the order system to the sales and inventory accounting systems. Customers submit orders for products through the online system and provide credit card information for payment. Each day, accounting department clerks print submitted orders from the online system. After credit authorization is verified with the credit card agency, the accounting department enters the sale into the sales journal. The accounting department then sends a copy of the order to warehouse personnel who process the shipment. The inventory system is updated based on bills of lading information forwarded to accounting after shipment.

Customers may return parts for full refund if returned within 30 days of submitting the order online. The company agrees to refund shipping costs incurred by the customer for returned goods.

a. Describe deficiencies in Parts for Wheels’ online sales system that may lead to material misstatements in the financial statements.

b. Identify changes in manual procedures that could be made to minimize risks, without having to reprogram the current online system.

c. Describe customer concerns about doing business online with Parts for Wheels. What types of controls could be implemented to address those concerns?

12-29 (Objective 12-6) Based on a cost-benefit analysis, management at First Community Bank decided to contract with TechnoAlogpy Saolgutions, aPloDcaFl dataEcenther aopneractoer, tro host all of the bank’s financial reporting applications. To avoid the significant costs of developing and maintaining its own data center, First Community contracts with Technology Solutions to provide IT server access in a highly secure, environmentally controlled data center facility owned by Technology Solutions. Similar to First Community, other busi- nesses also contract with Technology Solutions to host applications at the same data center.

The bank is directly linked through highly secure telecommunication lines to the data center, which allows bank personnel to transmit data to and from the data center as if the data center was owned by First Community. For a monthly fee, Technology Solutions supports the server hardware in an environment with numerous backup controls in the event power is lost or other hardware failures occur. Bank personnel are responsible for selecting and maintaining all application software loaded on Technology Solutions servers, and selected bank personnel have access to those servers located at Technology Solutions data center. Bank personnel enter all data, run applications hosted at Technology Solutions, and retrieve reports summarizing the processing of all bank transactions.

a. What risks might First Community assume with this approach to IT system support?

b. How does the use of Technology Solutions impact First Community’s internal controls?

c. What impact, if any, does reliance on Technology Solutions as the data center provider have on the audit of First Community’s financial statements?

Required

Required

Required

CASE

12-30 (Objectives 12-2, 12-3) The information systems (IS) department at Jacobsons Inc. consists of eight employees, including the IS Manager, Melinda Cullen. Melinda is responsible for the day-to-day oversight of the IS function and reports to Jacobsons’ chief operating officer (COO). The COO is a senior vice president responsible for the

Chapter 12 / THE IMPACT OF INFORMATION TECHNOLOGY 399

 

Part 2 / THE AUDIT PROCESS

overall retail operations who reports directly to the president and chief executive officer. The COO attends board of director meetings to provide an update of key operating performance issues. Because Melinda takes an active role in managing the IS department, the COO rarely discusses IS issues with the board or CEO. Melinda and the COO identify hardware and software needs and are authorized to approve those purchases.

In addition to Melinda, the IS department is composed of seven other individuals: three programmers, three operators, and one data control clerk. Melinda has been employed by Jacobsons for 12 years, working her way up through various positions in the department. Fortunately, she has been able to retain a fairly stable staff and has experienced minimal turnover. All IS personnel have been employed in their current positions since mid-2007. When hiring personnel, Melinda does extensive background checks on prospective employees, including reference, credit, and criminal checks. Melinda has developed a trust with each employee and, as a result, delegates extensively to each individual. This is especially beneficial because Melinda spends most of her time working with user departments in a systems analyst role, identifying changes needed to existing applications. She conducts weekly IS departmental meetings on Tuesday mornings. Each staff member attends, including night operators, to discuss issues affecting the performance of the department.

The three programmers are responsible for maintaining and updating systems and application software. The lead programmer is responsible for assigning duties among the programming staff. All three programmers have extensive experience with the operating, utility, security, and library software as well as all of Jacobsons’ application software packages. Programming assignments are made based on who is least busy among the programming staff at the time. This method of management keeps all programmers familiar with most software packages in use at Jacobsons and keeps programmers excited about the job tasks because of the variety of assignments they receive. Melinda encourages each programmer to take continuing education courses to keep current with the latest technical developments. In addition to programming responsibilities, the programming staff maintains the library of

programs and data tapes, which is located in a locked room nearby. The programming staff

maintains extensive logs of tape use and of changes made to program files.

The three operators consist of a day operator and two night operators. Most of the appli- cations are based on online inputting from various user departments for batch processing overnight. Thus, the heaviest volume of processing occurs during the night shift, although there is some daytime processing of payroll and general ledger applications. All operators are responsible for monitoring the operation of the equipment and correcting system- caused errors. In addition, they do routine monthly backup procedures. The computer operators have programming experience with the program language used in application programs. Occasionally, when a small change is identified for an application program, Melinda asks the day shift operator to implement that change to avoid overburdening the

programming staff.

Operators follow the production schedule prepared by Melinda, who consults with user

departments to develop the schedule. The day shift operator reviews the job processed log (which chronologically details the jobs processed) generated at the end of the previous night shift for deviations from the schedule, and the lead night shift operator reviews the job processed log generated at the end of the previous day shift for deviations from the schedule. If jobs processed reconcile to the job schedule, the job processed log is discarded. When there are deviations, the operator doing the review leaves a copy for Melinda, highlighting the deviation. Before doing batch processing jobs, the operators generate an input listing report that summarizes the number of online input entries submitted during the day for processing. This number is recorded and then later compared by the operators with the computer output generated after batch processing and file updating occur. This provides a check figure of the number of transactions processed. When the numbers agree, the output is submitted to the data control clerk. When the numbers disagree, the operators identify the error and resubmit the application for processing.

The data control clerk collates all computer output, including output reports and excep- tion listings. The data control clerk reviews exception reports and prepares correction forms

400

for reprocessing. Examples of changes that the data control clerk might make include correcting inputting errors (for example, amounts accidentally transposed) and preparing change request forms for changes to existing master files (examples include revising sales price lists and inventory product numbers in the sales master file and adding new employee names, addresses, and Social Security numbers to the payroll master file). After all corrections are made, the data control clerk distributes all computer output to the various user departments. User departments have high regard for the IS staff. Output reports are reconciled to input reports by users on a test basis quarterly.

You are the senior auditor assigned to the audit of Jacobsons. The audit partner has asked you to assist in doing the IS general controls review. The partner has asked you to review this narrative information and respond to the following questions:

1. What controls and deficiencies exist in the lines of reporting from IS to senior management? If you note any deficiencies, provide recommendations that can be included in the management letter.

2. What is your assessment of how Melinda Cullen fulfills her IS management responsi- bilities? Identify tasks that she does that strengthen the department. Which of her tasks cause you concern? What changes in her day-to-day responsibilities would you make?

3. What is your assessment of the programming function at Jacobsons? What are the strengths? What are the deficiencies? Make recommendations for improvement.

4. What is your assessment of the IS operations function at Jacobsons? What are the strengths? What are the deficiencies? Make recommendations for improvement.

5. What is your assessment of the data control function at Jacobsons? What are the strengths? What are the deficiencies? Make recommendations for improvement.

6. Make recommendations for improving controls over the involvement of users.

Required

ACL PROBLEM

12-31 (Objective 12-5) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material preceding the instructions about “Quick Sort” before locating the appropriate com- mand to answer questions a-f. For this problem use the Metaphor_Trans_2002 file in ACL_ Demo, which is a file of purchase transactions. The suggested command or other source of information needed to solve the problem requirement is included at the end of each question.

a. Use Quick Sort for each column in the table and identify any concerns you have about Required the data. (Quick Sort)

b. Determine the total cost of all purchases, ignoring any concerns in part a. (Total)

c. Determine if there are any duplicates or missing numbers in the voucher file (Invoice column). State your audit concerns with any gaps or duplicates. Provide a possible explanation for any gaps or duplicates that you find. (Gaps and Duplicates)

d. Determine and print the total purchases for the period by product. (Summarize) Determine if the total cost is the same as in part b. (Total) What product number has the greatest amount of purchases? (Quick Sort)

e. Determine and print the percent of total purchases by product. Save the classified file for use in requirement f. (Classify) Based on that output, what percentage is product number 024133112 of the total amount?

f. Using the classified file from requirement e, stratify and print the purchases by product. Exclude all items smaller than $1,000. Sort the items to determine the smallest and largest amounts. Use the smallest amount as the minimum in the Stratify window. Because the largest amount is significantly larger than all other items, use the second highest amount as the maximum in the Stratify window. (Filter, Quick Sort, and Stratify)

Chapter 12 / THE IMPACT OF INFORMATION TECHNOLOGY 401

 

INTERNET PROBLEM 12-1: ASSESSING IT GOVERNANCE

Required

The proliferation of information technology (IT) has made governance of IT an important issue for businesses of all sizes and types, as well as their auditors. The IT Governance Institute has developed a wide range of resources for organizations, auditors, and educators to use in addressing IT governance matters and simultaneously leveraging the benefits of technology. Visit the IT Governance Institute’s web site (www.itgi.org). Read the “About IT Governance” tab to answer the following questions.

a. Why is IT governance important?

b. How does IT governance relate to other aspects of the organization’s governance?

c. How would an auditor likely view a company’s IT environment if the board and senior management were actively engaged in IT governance oversight?

Chapter 13

REVIEW QUESTIONS

13-1 (Objective 13-1) 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 when auditing internal control over financial reporting.

13-2 (Objective 13-1) What is the purpose of risk assessment procedures and how do they differ from the four other types of audit tests?

13-3 (Objective 13-1) 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.

13-4 (Objective 13-1) Distinguish between a test of control and a substantive test of trans- actions. Give two examples of each.

13-5 (Objectives 13-1, 13-4) 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.

13-6 (Objective 13-1) 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?

13-7 (Objectives 13-2, 13-4) 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 audit 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.”

 

13-8 (Objectives 13-1, 13-2) 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.

13-9 (Objective 13-1) Distinguish between substantive tests of transactions and tests of details of balances. Give one example of each for the acquisition and payment cycle.

13-10 (Objective 13-3) The auditor of Ferguson’s Inc. identified two internal controls in the sales and collection 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 lading, 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.

13-11 (Objective 13-4) Assume that the client’s internal controls over the recording and classifying of fixed asset additions are considered deficient because the individual respon- sible for recording new acquisitions has inadequate technical training and limited experience in accounting. How will this situation affect the evidence you should accumu- late in auditing fixed assets as compared with another audit in which the controls are excellent? Be as specific as possible.

13-12 (Objective 13-2) For each of the eight types of evidence discussed in Chapter 7, identify whether it is applicable for risk assessment procedures, tests of controls, sub- stantive tests of transactions, analytical procedures, and tests of details of balances.

13-13 (Objective 13-2) Rank the following types of tests from most costly to least costly: analytical procedures, tests of details of balances, risk assessment procedures, tests of controls, and substantive tests of transactions.

Chapter 13 / OVERALL AUDIT PLAN AND AUDIT PROGRAM 429

13-14 (Objective 13-2) In Figure 13-3 (p. 411), 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.

13-15 (Objective 13-4) Table 13-3 (p. 413) 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?

13-16 (Objective 13-5) State the four-step approach to designing tests of controls and substantive tests of transactions.

13-17 (Objective 13-5) Explain the relationship between the methodology for designing tests of controls and substantive tests of transactions in Figure 13-4 (p. 415) and the methodology for designing tests of details of balances in Figure 13-6 (p. 417).

13-18 (Objective 13-5) 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 so. What does the auditor do if the assumptions are wrong?

13-19 (Objective 13-5) Explain the relationship of tolerable misstatement, inherent risk, and control risk to planned tests of details of balances.

13-20 (Objective 13-5) List the eight balance-related audit objectives in the verification of the ending balance in inventory and provide one useful audit procedure for each of the objectives.

13-21 (Objective 13-7) 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.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

13-22 (Objective 13-1, 13-5, 13-7) The following questions concern types of audit tests. Choose the best response.

a. TAhepauadigtorolookPs DforFan iEndnicahtioan noncdeuprlicate sales invoices to see whether the accuracy of invoices has been verified. This is an example of
(1) a test of details of balances.
(2) a test of control.
(3) a substantive test of transactions.
(4) both a test of control and a substantive test of transactions.

b.An auditor’s decision either to apply analytical procedures as substantive tests or to per- form substantive tests of transactions and account balances usually is determined by the (1) availability of data aggregated at a high level.
(2) relative effectiveness and efficiency of the tests.
(3) timing of tests performed after the balance sheet date. (4) auditor’s familiarity with industry trends.

c. The auditor faces a risk that the audit will not detect material misstatements that occur in the accounting process. To minimize this risk, the auditor relies primarily on
(1) substantive tests. (3) internal control.
(2) tests of controls. (4) statistical analysis.

d.A conceptually logical approach to the auditor’s evaluation of internal control consists of the following four steps:
I. Determining the internal controls that should prevent or detect errors and fraud. II. Identifying control deficiencies to determine their effect on the nature, timing, or extent of auditing procedures to be applied and suggestions to be made to the client.

  1. Determining whether the necessary internal control procedures are prescribed
    and are being followed satisfactorily.
  2. Considering the types of errors and fraud that can occur.

What should be the order in which these four steps are performed?

.    (1)  I,II,III,andIV (3) III,IV,I,andII

.    (2)  I,III,IV,andII (4) IV,I,III,andII

Part 2 / THE AUDIT PROCESS

430

13-23 (Objective 13-1) The following questions deal with tests of controls. Choose the best response.

a. Which of the following statements about tests of controls is most accurate?

.                      (1)  Auditing procedures cannot concurrently provide both evidence of the effective-
ness of internal control procedures and evidence required for substantive tests.

.                      (2)  Tests of controls include observations of the proper segregation of duties.

.                      (3)  Tests of controls provide direct evidence about monetary misstatements in trans-
actions.

.                      (4)  Tests of controls ordinarily should be performed as of the balance sheet date or
during the period subsequent to that date.

b.To support the auditor’s initial assessment of control risk below maximum, the auditor
performs procedures to determine that internal controls are operating effectively. Which of the following audit procedures is the auditor performing?

.                      (1)  Tests of details of balances (3) Tests of controls

.                      (2)  Substantive tests of transactions (4) Tests of trends and ratios

c. The primary objective of performing tests of controls is to obtain

.                      (1)  a reasonable degree of assurance that the client’s internal controls are operating
effectively on a consistent basis throughout the year.

.                      (2)  sufficient,appropriateauditevidencetoaffordareasonablebasisfortheauditor’s
opinion, without the need for additional evidence.

.                      (3)  assurances that informative disclosures in the financial statements are reasonably
adequate.

.                      (4)  knowledgeandunderstandingoftheclient’sprescribedproceduresandmethods.

d.To test the effectiveness of controls, an auditor ordinarily selects from a variety of tech- niques, including
(1) analysis. (3) reperformance.
(2) confirmation. (4) comparison.

 

DISCUSSION QUESTIONS AND PROBLEMS

13-24 (Objectives 13-1, 13-2) The following are 11 audit procedures taken from an audit program:

1. Foot the accounts payable trial balance and compare the total with the general ledger.

2.Confirm accounts payable balances directly with vendors.

3.Account for a sequence of checks in the cash disbursements journal to determine
whether any have been omitted.

4.Examine vendors’ invoices to verify the ending balance in accounts payable.

5.Compare the balance in payroll tax expense with previous years. The comparison
takes the increase in payroll tax rates into account.

6.Examine the internal auditor’s initials on monthly bank reconciliations as an
indication of whether they have been reviewed.

7.Examine vendors’ invoices and other documentation in support of recorded trans-
actions in the acquisitions journal.

8.Multiply the commission rate by total sales and compare the result with commission
expense.

9.Examine vendors’ invoices and other supporting documents to determine whether
large amounts in the repair and maintenance account should be capitalized.

  1. Discuss the duties of the cash disbursements clerk with him and observe whether he
    has responsibility for handling cash or preparing the bank reconciliation.
  2. Inquire about the accounts payable supervisor’s monthly review of a computer- generated exception report of receiving reports and purchase orders that have not
    been matched with a vendor invoice.

a. Indicate whether each procedure is a test of control, substantive test of transactions, Required
analytical procedure, or a test of details of balances.

b.Identify the type of evidence for each procedure.

Chapter 13 / OVERALL AUDIT PLAN AND AUDIT PROGRAM 431

432

Required

13-25 (Objectives 13-1, 13-2) The following are audit procedures from different transaction cycles:

1. Examine duplicate copy of shipping documents for evidence that quantities were verified before shipment.

2.Select a sample of payroll checks and agree hours to employee time records.

3.Use audit software to foot and cross-foot the sales journal and trace the balance to
the general ledger.

4.Examine voucher packages and related vendor invoices for evidence of approval of
account classification.

5.Trace a sample of shipping documents to entry in the sales journal.

6.Examine a sample of warehouse removal slips for signature of authorized official.

7. Select a sample of entries in the cash receipts journal and trace to posting in individual

customer accounts receivable records.
8. Select a sample of sales invoices and agree prices to the approved price list.

a. For each audit procedure, identify whether it is a test of control or a substantive test of transactions.

b. For each audit procedure, identify the transaction-related audit objective or objectives being satisfied.

13-26 (Objectives 13-1, 13-2, 13-3, 13-6) The following are audit procedures from different transaction cycles:

1. Use audit software to foot and cross-foot the cash disbursements journal and trace the balance to the general ledger.

2.Select a sample of entries in the acquisitions journal and trace each one to a related vendor’s invoice to determine whether one exists.

3.Examine documentation for acquisition transactions before and after the balance sheet date to determine whether they are recorded in the proper period.

Required

5. Compute inventory turnover for each major product and compare with previous years.

6. Confirm a sample of notes payable balances, interest rates, and collateral with lenders. 7. Use audit software to foot the accounts receivable trial balance and compare the

balance with the general ledger.

a. For each audit procedure, identify the transaction cycle being audited.

b. For each audit procedure, identify the type of evidence.

c. For each audit procedure, identify whether it is a test of control or a substantive test.

d. For each substantive audit procedure, identify whether it is a substantive test of trans- actions, a test of details of balances, or an analytical procedure.

e. For each test of control or substantive test of transactions procedure, identify the transaction-related audit objective or objectives being satisfied.

f . For each analytical procedure or test of details of balances procedure, identify the balance-related audit objective or objectives being satisfied.

13-27 (Objectives 13-1, 13-5, 13-6) The following are independent internal controls commonly found in the acquisition and payment cycle. Each control is to be considered independently.

1. At the end of each month, an accounting clerk accounts for all prenumbered receiving reports (documents evidencing the receipt of goods) issued during the month, and traces each one to the related vendor’s invoice and acquisitions journal entry. The clerk’s tests do not include testing the quantity or description of the merchandise received.

2.The cash disbursements clerk is prohibited from handling cash. The bank account is reconciled by another person even though the clerk has sufficient expertise and time to do it.

Part 2 / THE AUDIT PROCESS

4. Inquire of the credit manager whether each account receivable on the aged trial balance is collectible.

 

3.Before a check is prepared to pay for acquisitions by the accounts payable depart- ment, the related purchase order and receiving report are attached to the vendor’s invoice being paid. A clerk compares the quantity on the invoice with the receiving report and purchase order, compares the price with the purchase order, recomputes the extensions, re-adds the total, and examines the account number indicated on the invoice to determine whether it is correctly classified. He indicates his performance of these procedures by initialing the invoice.

4.Before a check is signed by the controller, she examines the supporting docu- mentation accompanying the check. At that time, she initials each vendor’s invoice to indicate her approval.

5.After the controller signs the checks, her secretary writes the check number and the date the check was issued on each of the supporting documents to prevent their reuse.

a. For each of the internal controls, state the transaction-related audit objective(s) the control is meant to fulfill.

b.For each control, list one test of control the auditor could perform to test the effective- ness of the control.

c. For each control, list one substantive test the auditor could perform to determine whether financial misstatements are actually taking place.

13-28 (Objectives 13-1, 13-5, 13-6) The following internal controls for the acquisition and payment cycle were selected from a standard internal control questionnaire.

1. Checks are mailed by the owner or manager or a person under her supervision after signing.

2.All supporting documents are cancelled after checks are signed or electronic funds transfers are approved.

3.The authorized signer compares data on supporting documents with checks and electronic funds transfer authorizations.

4.Vendors’ invoices are recalculated before payment.

5.Approved purchase orders are rAeqpuiraedgfoor all aPcqDuisFitionEs onf ghooadsn. cer

6. Prenumbered receiving reports are prepared as support for acquisitions and numerically

accounted for.

7.Dates on receiving reports are compared with vendors’ invoices before entry into the
acquisitions journal.

8.The accounts payable master file is updated, balanced, and reconciled to the general
ledger monthly.

9.Account classifications are reviewed by someone other than the preparer.

  1. All checks are signed by the owner or manager.

a. For each control, identify which element of the five categories of control activities is applicable (separation of duties, proper authorization, adequate documents or records, physical control over assets and records, or independent checks on performance).

b.For each control, state which transaction-related audit objective(s) is (are) applicable.

c. For each control, write an audit procedure that could be used to test the control for effectiveness.

d.For each control, identify a likely misstatement, assuming that the control does not exist or is not functioning.

e. For each likely misstatement, identify a substantive audit procedure to determine whether the misstatement exists.

13-29 (Objective 13-3) Beds and Spreads, Inc. specializes in bed and bath furnishings. Its inventory system is linked through the Internet to key suppliers. The auditor identified the following internal controls in the inventory cycle:

1. The computer initiates an order only when perpetual inventory levels fall below prespecified inventory levels in the inventory master file.

2. The sales and purchasing department managers review inventory reorder points on a monthly basis for reasonableness. Approved changes to reorder points are entered

Required

Chapter 13 / OVERALL AUDIT PLAN AND AUDIT PROGRAM 433

Required

Required

into the master file by the purchasing department manager and an updated printout is generated for final review. Both managers verify that all changes were entered correctly and initial the final printout indicating final approval. These printouts are maintained in the purchasing department.

3.The computer will initiate a purchase order only for inventory product numbers maintained in the inventory master file.

4.The purchasing department manager reviews a computer-generated exception report that highlights weekly purchases that exceed $10,000 per vendor.

5.Sales clerks send damaged merchandise on the store shelves to the back storage room. The sales department manager examines the damaged merchandise each month and pre- pares a listing showing the estimated salvage value by product number. The accounting department uses the listing to prepare a monthly adjustment to recorded inventory values.

a. Consider each of the preceding controls separately. Identify whether the control is a(n)

.    (1)  automated control embedded in computer software.

.    (2)  manualcontrolwitheffectivenessbasedsignificantlyonIT-generatedinformation.

.    (3)  manualcontrolwitheffectivenessnotsignificantlyreliantonIT-generatedinfor-
mation.

b. Describe how the extent of testing of each control will be affected in subsequent years

if general controls are effective, particularly controls over program and master file changes.

13-30 (Objectives 13-5, 13-7) Following are evidence decisions for the three audits described in Figure 13-3 on page 411:

Required

3. The auditor decided it was possible to assess control risk below the maximum.

4.The auditor performed substantive tests.

5.This audit was likely the least expensive to conduct.

6.The auditor confirmed receivables at an interim date.

7.The auditor identified effective controls and also identified some deficiencies in controls.

8.The auditor performed tests of controls.

a. Explain why Audit B represents the maximum amount of reliance that can be placed

on internal control. Why can’t all the audit assurance be obtained by tests of controls? b. Explain why the auditor may not place the maximum extent of reliance on controls in

Audit B and Audit C.
c. For each of the eight evidence decisions, indicate whether the evidence decision

relates to each of the audits described above. Every evidence decision relates to at least one of the audits, and some may relate to two or all three audits.

13-31 (Objectives 13-4, 13-5) Following are several decisions that the auditor must make in an audit of a nonpublic company. Letters indicate alternative conclusions that could be made.

Audit A Audit B Audit C

Ineffective client internal controls
Very effective client internal controls Somewhat effective client internal controls

Evidence Decisions

1. The auditor performed extensive positive confirmations at the balance sheet date. 2. The auditor performed extensive tests of controls and minimal substantive tests.

 

Decisions

1. Determine whether it is cost effective to perform tests of controls.

2. Perform substantive tests of details of balances.

3. Complete initial assessment of control risk.

4. Perform tests of controls.

Alternative Conclusions

A. It is cost effective
B. It is not cost effective

C. Perform reduced tests D. Performexpandedtests

E. Controls are effective F. Controls are ineffective

G. Controls are effective H. Controls are ineffective

Part 2 / THE AUDIT PROCESS

434

a. Identify the sequence in which the auditor should make decisions 1 to 4.

b.For the audit of the sales and collection cycle and accounts receivable, an auditor reached the following conclusions: A, D, E, H. Put the letters in the appropriate sequence and evaluate whether the auditor’s logic was reasonable. Explain your answer.

c. For the audit of inventory and related inventory cost records, an auditor reached the following conclusions: B, C, E, G. Put the letters in the appropriate sequence and evaluate whether the auditor used good professional judgment. Explain your answer.

d.For the audit of property, plant, and equipment and related acquisition records, an auditor reached the following conclusions: A, C, F, G. Put the letters in the appropriate sequence and evaluate whether the auditor used good professional judgment. Explain your answer.

e. For the audit of payroll expenses and related liabilities, an auditor recorded the following conclusions: D, F. Put the letters in the appropriate sequence and evaluate whether the auditor used good professional judgment. Explain your answer.

13-32 (Objective 13-4) The following are three situations, all involving nonpublic companies, in which the auditor is required to develop an audit strategy:

1. The client has inventory at approximately 50 locations in a three-state region. The inventory is difficult to count and can be observed only by traveling by automobile. The internal controls over acquisitions, cash disbursements, and perpetual records are considered effective. This is the fifth year that you have done the audit, and audit results in past years have always been excellent. The client is in excellent financial condition.

2.This is the first year of an audit of a medium-sized company that is considering
selling its business because of severe underfinancing. A review of the acquisition and
payment cycle indicates that controls over cash disbursements are excellent but
controls over acquisitions cannot be considered effective. The client lacks receiving

Required

reports and a policy as to the proper timing to record acquisitions. When you review

 

the general ledger, you observe that there are many large adjusting entries to correct

accounts payable.
3. You are doing the audit of a small loan company with extensive receivables from cus-

tomers. Controls over granting loans, collections, and loans outstanding are considered effective, and there is extensive follow-up of all outstanding loans weekly. You have recommended a new computer system for the past 2 years, but manage- ment believes the cost is too great, given their low profitability. Collections are an ongoing problem because many of the customers have severe financial problems. Because of adverse economic conditions, loans receivable have significantly increased and collections are less than normal. In previous years, you have had relatively few adjusting entries.

a. For audit 1, recommend an evidence mix for the five types of tests for the audit of inventory and cost of goods sold. Justify your answer. Include in your recommen- dations both tests of controls and substantive tests.

b.For audit 2, recommend an evidence mix for the audit of the acquisition and payment cycle, including accounts payable. Justify your answer.

c. For audit 3, recommend an evidence mix for the audit of outstanding loans. Justify your answer.

13-33 (Objective 13-4) Kim Bryan, a new staff auditor, is confused by the inconsistency of the three audit partners she has been assigned to on her first three audit engagements. On the first engagement, she spent a considerable amount of time in the audit of cash disbursements by examining cancelled checks, electronic payments, and supporting documentation, but almost no testing was spent in the verification of fixed assets. On the second engagement, a different partner had her do less intensive tests in the cash disburse- ments area and take smaller sample sizes than in the first audit, even though the company was much larger. On her most recent engagement under a third audit partner, there was a

Required

Chapter 13 / OVERALL AUDIT PLAN AND AUDIT PROGRAM 435

Required

thorough test of cash disbursement transactions, far beyond that of the other two audits, and an extensive verification of fixed assets. In fact, this partner insisted on a complete physical examination of all fixed assets recorded on the books. The total audit time on the most recent audit was longer than that of either of the first two audits despite the smaller size of the company. Bryan’s conclusion is that the amount of evidence to accumulate depends on the audit partner in charge of the engagement.

a. State several factors that can explain the difference in the amount of evidence accu- mulated in each of the three audit engagements as well as the total time spent.

b. What could the audit partners have done to help Bryan understand the difference in the audit emphasis on the three audits?

c. Explain how these three audits are useful in developing Bryan’s professional judg- ment. How could the quality of her judgment have been improved on the audits?

d. Which audit most likely represents an integrated audit of a public company’s financial statements and internal control over financial reporting?

13-34 (Objectives 13-5, 13-7) The following are parts of a typical audit for a company with a fiscal year-end of July 31.

1. Confirm accounts payable.

2.Do tests of controls and substantive tests of transactions for the acquisition and
payment and payroll and personnel cycles.

3.Do other tests of details of balances for accounts payable.

4.Do tests for review of subsequent events.

5.Accept the client.

6.Issue the audit report.

7.Understand internal control and assess control risk.

8.Do analytical procedures for accounts payable.

9. Set acceptable audit risk and decide preliminary judgment about materiality and

Required

CASES

a. Identify the phase of the audit in which each activity occurs.

b. Put parts 1 through 9 of the audit in the sequential order in which you will expect them to be performed in a typical audit.

c. Identify those parts that will frequently be done before July 31.

 

tolerable misstatement.

Part 2 / THE AUDIT PROCESS

13-35 (Objectives 13-4, 13-5) Gale Brewer, CPA, has been the partner in charge of the audit of Merkle Manufacturing Company, a nonpublic company, for 13 years. Merkle has had excellent growth and profits in the past decade, primarily as a result of the excellent leader- ship provided by Bill Merkle and other competent executives. Brewer has always enjoyed a close relationship with the company and prides himself on having made several constructive comments over the years that have aided in the success of the firm. Several times in the past few years, Brewer’s CPA firm has considered rotating a different audit team on the engage- ment, but this has been strongly resisted by both Brewer and Merkle.

For the first few years of the audit, internal controls were inadequate and the account- ing personnel had inadequate qualifications for their responsibilities. Extensive audit evidence was required during the audit, and numerous adjusting entries were necessary. However, because of Brewer’s constant prodding, internal controls improved gradually and competent personnel were hired. In recent years, there were normally no audit adjustments required, and the extent of the evidence accumulation was gradually reduced. During the past 3 years, Brewer was able to devote less time to the audit because of the relative ease of conducting the audit and the cooperation obtained throughout the engagement.

436

In the current year’s audit, Brewer decided that the total time budget for the engagement should be kept approximately the same as in recent years. The senior in charge of the audit, Phil Warren, was new on the job and highly competent, and he had the reputation of being able to cut time off the budget. The fact that Merkle had recently acquired a new division through merger will probably add to the time, but Warren’s efficiency will probably compensate for it.

The interim tests of controls took somewhat longer than expected because of the use of several new assistants, a change in the accounting system to computerize the inventory and other accounting records, a change in accounting personnel, and the existence of a few more errors in the tests of the system. Neither Brewer nor Warren was concerned about the budget deficit, however, because they could easily make up the difference at year-end.

At year-end, Warren assigned the responsibility for inventory to an assistant who also had not been on the audit before but was competent and extremely fast at his work. Even though the total value of inventory increased, he reduced the size of the sample from that of other years because there had been few errors in the preceding year. He found several items in the sample that were overstated as a result of errors in pricing and obsolescence, but the combination of all of the errors in the sample was immaterial. He completed the tests in 25% less time than the preceding year. The entire audit was completed on schedule and in slightly less time than the preceding year. There were only a few adjusting entries for the year, and only two of them were material. Brewer was extremely pleased with the results and wrote a letter to Warren and the inventory assistant complimenting them on the audit.

Six months later, Brewer received a telephone call from Merkle and was informed that the company was in serious financial trouble. Subsequent investigation revealed that the inventory had been significantly overstated. The major cause of the misstatement was the inclusion of obsolete items in inventory (especially in the new division), errors in pricing as a result of the new computer system, and the inclusion of nonexistent inventory in the final

inventory listing. The new controller had intentionally overstated the inventory to

 

compensate for the reduction in sales volume from the preceding year.
a. List the major deficiencies in the audit and state why they took place.
b. What things should have been apparent to Brewer in the conduct of the audit? c. If Brewer’s firm is sued by creditors, what is the likely outcome?

13-36 (Objectives 13-4, 13-5) McClain Plastics has been an audit client of Belcor, Rich, Smith & Barnes, CPAs (BRS&B), for several years. McClain Plastics was started by Evers McClain, who owns 51% of the company’s stock. The balance is owned by about 20 stockholders who are investors with no operational responsibilities. McClain Plastics makes products that have plastic as their primary material. Some are made to order, but most products are made for inventory. An example of a McClain-manufactured product is a plastic chair pad that is used in a carpeted office. Another is a plastic bushing that is used with certain fastener systems.

McClain has grown from a small, two-product company, when they first engaged BRS&B, to a successful diverse company. At the time Randall Sessions of BRS&B became manager of the audit, annual sales had grown to $200 million and profits to $10.9 million. Historically, the company presented no unusual audit problems, and BRS&B had issued an unqualified opinion every year.

The audit approach BRS&B always used on the audit of McClain Plastics was a “sub- stantive” audit approach. Under this approach, the in-charge auditor obtained an under- standing of internal control as part of the risk assessment procedures, but control risk was assessed at the maximum (100%). Extensive analytical procedures were done on the income statement, and unusual fluctuations were investigated. Detailed audit procedures emphasized balance sheet accounts. The theory was that if the balance sheet accounts were correct at year-end and had been audited as of the beginning of the year, then retained earnings and the income statement must be correct.

Required

Chapter 13 / OVERALL AUDIT PLAN AND AUDIT PROGRAM 437

Required

a. Decide which of the following will likely be done under both a reducing control risk approach and a substantive approach:

(1) Assess inherent risk.
(2) Obtain an understanding of internal control. (3) Perform tests of controls.
(4) Perform analytical procedures.
(5) Assess planned detection risk.

b.What advantages does the reducing control risk approach Sessions plans to use have over the substantive approach previously used in the audit of McClain Plastics?

c. What advantages did the substantive approach have over the reducing control risk approach?

Part II

The engagement partner agreed with Sessions’s recommended approach. In planning the audit evidence for detailed inventory tests, the audit risk model was applied with the following results:

Part I

In evaluating the audit approach for McClain for the current year’s audit, Sessions believed that a substantive approach was really only appropriate for the audits of small nonpublic companies. In his judgment, McClain Plastics, with sales of $200 million and 146 employees, had reached the size where it was not economical, and probably not wise, to concentrate all the tests on the balance sheet. Furthermore, although McClain is not a public company, Sessions recognized that similar public companies are required by Section 404 of the Sarbanes–Oxley Act and related PCAOB standards to have an integrated audit of the financial statements and internal control over financial reporting. Therefore, he designed an audit program that emphasized identifying internal controls in all major transaction cycles and included tests of controls. The intended economic benefit of this “reducing control risk” approach was that the time spent testing controls will be more than offset by reduced tests of details of the balance sheet accounts.

In planning tests of inventories, Sessions used the audit risk model included in auditing standards to determine the number of inventory items BRS&B will test at year-end. Because of the number of different products, features, sizes, and colors, McClain’s inventory consisted of 2,450 different items. These were maintained on a perpetual inventory manage- ment system that used a relational database.

In using the audit risk model for inventories, Sessions believed that an audit risk of

5% was acceptable. He assessed inherent risk as high (100%) because inventory, by its

nature, is subject to many types of misstatements. Based on his understanding of the

relevant transaction cycles, Sessions believed that internal controls were good. He

therefore assessed control risk as low (50%) before performing tests of controls. Sessions

also planned to use analytical procedures for tests of inventory. These planned tests

included comparing gross profit margins by month and reviewing for slow-moving items.

Sessions believed that these tests will provide assurance of 40%. Substantive tests of details

will include tests of inventory quantities, costs, and net realizable values at an interim date

2 months before year-end. Cutoff tests will be done at year-end. Inquiries and analytical

 

procedures will be relied on for assurance about events between the interim audit date and

fiscal year-end.

Part 2 / THE AUDIT PROCESS

where:

TDR =

TDR = AAR = IR = CR = APR =

AAR

IR × CR × APR

test of details risk acceptable audit risk inherent risk
control risk
analytical procedures risk

438

Therefore, using Sessions’s assessments and judgments as described previously, TDR = .05

a. Explain what .17 means in this audit.

b.Calculate TDR assuming that Sessions had assessed control risk at 100% and all other risks as they are stated.

c. Explain the effect of your answer in requirement b on the planned audit procedures and sample size in the audit of inventory compared with the .17 calculated by Sessions.

Part III

Although the planning went well, the actual testing yielded some surprises. When con- ducting tests of controls over acquisitions and additions to the perpetual inventory, the staff person performing the tests found that the exception rates for several key controls were significantly higher than expected. As a result, the staff person considered internal control to not be operating effectively, supporting an 80% control risk rather than the 50% level used. Accordingly, the staff person “reworked” the audit risk model as follows:

TDR = .05
1.0 × .8 × .6

TDR = .10
A 10% test of details risk still seemed to the staff person to be in the “moderate” range, so

he recommended no increase in planned sample size for substantive tests.

Do you agree with the staff person’s revised judgments about the effect of tests of controls on planned substantive tests? Explain the nature and basis of any disagreement. Also, describe the implications of these results on the auditor’s report on internal control over financial reporting.

INTERNET PROBLEM 13-1: ASSESSING EFFECTS OF EVIDENCE MIX

Auditors develop overall audit plans to ensure that they obtain sufficient appropriate audit evidence. The timing and extent of audit procedures auditors use is a matter of professional judgment, which depends upon a number of factors. Decisions about the mix of audit procedures and the timing of procedures significantly impact the date on which the audit report is issued. Visit the company Web sites for Google Inc. (www.google.com), Cisco Systems, Inc. (www.cisco.com), and McDonald’s Corporation (www.aboutmcdonalds.com). Search under “Investor Relations” for the most recent annual report and locate the indepen- dent auditor’s report.

a. Identify the year-end for each company. Did any company have a year-end other than Required December 31st? Will the company’s year-end have any impact on the audit procedures
used and their timing?

b.Indicate the number of days between each company’s year-end and the date of the audit report. What factors may impact the number of days to issue the audit report?

c. Based on the number of days between each company’s year-end and the date of the audit report, and your knowledge of each company’s operations, on which audit do you think the auditors placed the greatest reliance on substantive tests of details of balances? Explain.

Chapter 14

REVIEW QUESTIONS

deposits made to the bank

Sales and collection cycle—involves the decisions and processes necessary for the transfer of the ownership of goods and services to customers after they are made available for sale; it begins with a request by a customer and ends with the conversion of material or service into an account receivable, and ultimately into cash

14-1 (Objective 14-2) Describe the nature of the following documents and records and explain their use in the sales and collection cycle: bill of lading, sales invoice, credit memo, remittance advice, monthly statement to customers.

14-2 (Objective 14-2) Explain the importance of proper credit approval for sales. What effect do adequate controls in the credit function have on the auditor’s evidence accumu- lation?

14-3 (Objective 14-2) Distinguish between the sales journal and the accounts receivable master file. What type of information is recorded in each and how do these accounting records relate?

14-4 (Objective 14-2) BestSellers.com sells fiction and nonfiction books to customers through the company’s Web site. Customers place orders for books via the Web site by providing their name, address, credit card number, and expiration date. What internal controls could BestSellers.com implement to ensure that shipments of books occur only for customers who have the ability to pay for those books? At what point will BestSellers.com be able to record the sale as revenue?

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

14-5 (Objective 14-3) List the transaction-related audit objectives for the audit of sales transactions. For each objective, state one internal control that the client can use to reduce the likelihood of misstatements.

14-6 (Objective 14-3) State one test of control and one substantive test of transactions that the auditor can use to verify the following sales transaction-related audit objective: Recorded sales are stated at the proper amounts.

14-7 (Objective 14-3) List the most important duties that should be segregated in the sales and collection cycle. Explain why it is desirable that each duty be segregated.

14-8 (Objective 14-3) Explain how prenumbered shipping documents and sales invoices can be useful controls for preventing misstatements in sales.

14-9 (Objective 14-3) What three types of authorizations are commonly used as internal controls for sales? For each authorization, state a substantive test that the auditor could use to verify whether the control was effective in preventing misstatements.

14-10 (Objective 14-3) Explain the purpose of footing and cross-footing the sales journal and tracing the totals to the general ledger.

14-11 (Objective 14-4) What is the difference between the auditor’s approach in verifying sales returns and allowances and that for sales? Explain the reasons for the difference.

14-12 (Objective 14-5) Explain why auditors usually emphasize the detection of fraud in the audit of cash receipts. Is this consistent or inconsistent with the auditor’s responsibility in the audit? Explain.

14-13 (Objective 14-5) List the transaction-related audit objectives for the verification of cash receipts. For each objective, state one internal control that the client can use to reduce the likelihood of misstatements.

14-14 (Objective 14-5) List several audit procedures that the auditor can use to determine whether all cash received was recorded.

purpose.

14-16 (Objective 14-5) Explain what is meant by lapping and discuss how the auditor can uncover it. Under what circumstances should the auditor make a special effort to uncover lapping?

14-17 (Objective 14-6) What audit procedures are most likely to be used to verify accounts receivable written off as uncollectible? State the purpose of each of these procedures.

14-18 (Objectives 14-3, 14-5) State the relationship between the confirmation of accounts receivable and the results of the tests of controls and substantive tests of transactions.

14-19 (Objectives 14-3, 14-5) Under what circumstances is it acceptable to perform tests of controls and substantive tests of transactions for sales and cash receipts at an interim date?

14-20 (Objective 14-3) Diane Smith, CPA, performed tests of controls and substantive tests of transactions for sales for the month of March in an audit of the financial statements for the year ended December 31, 2011. Based on the excellent results of both the tests of controls and the substantive tests of transactions, she decided to significantly reduce her substantive tests of details of balances at year-end. Evaluate this decision.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

14-21 (Objectives 14-3, 14-4, 14-5, 14-6) The following questions deal with internal controls in the sales and collection cycle. Choose the best response.

a. The accounting system will not post a sales transaction to the sales journal without a valid bill of lading number. This control is most relevant to which transaction-related objective for sales?

(1) Accuracy (3) Completeness

(2) Occurrence (4) Posting and summarization

14-15 (Objective 14-5) Explain what is meant by a proof of cash receipts and state its

Chapter 14 / AUDIT OF THE SALES AND COLLECTION CYCLE 467

 

b. The accounting system automatically obtains the unit price based on scans of bar codes for merchandise sold. This control is most relevant to which transaction-related objective for sales?

(1) Accuracy

(2) Occurrence

(3) Completeness

(4) Posting and summarization

c. Which of the following controls would be most effective in detecting a failure to record cash received from customers paying on their accounts?

(1) A person in accounting reconciles the bank deposit to the cash receipts journal.

(2) Transactions recorded in the cash receipts journal are posted on a real-time basis

to the accounts receivable master file.

(3) Monthly statements are sent to customers and any discrepancies are resolved by

someone independent of cash handling and accounting.

(4) Deposits of cash received are made daily.

d. A key internal control in the sales and collection cycle is the separation of duties between cash handling and record keeping. The objective most directly associated with this control is to verify that

(1) cash receipts recorded in the cash receipts journal are reasonable.

(2) cash receipts are correctly classified.

(3) recorded cash receipts result from legitimate transactions. (4) existing cash receipts are recorded.

14-22 (Objectives 14-3, 14-4) For each of the following types of misstatements (parts a through d), select the control that should have prevented the misstatement:

a. A manufacturing company received a substantial sales return in the last month of the year, but the credit memorandum for the return was not prepared until after the auditors had completed their testing. The returned merchandise was included in the

control is prepared periodically.

(4) Receiving reports are prepared for all materials received and such reports are

accounted for on a timely basis.

b. Which of the following controls most likely will be effective in offsetting the tendency of sales personnel to maximize sales volume at the expense of high bad debt write-offs?

(1) Employees responsible for authorizing sales and bad debt write-offs are denied

access to cash.

(2) Shippingdocumentsandsalesinvoicesarematchedbyanemployeewhodoesnot

have the authority to write off bad debts.

(3) Employees involved in the credit-granting function are separated from the sales

function.

(4) Subsidiary accounts receivable records are reconciled to the control account by an

employee independent of the authorization of credit.

c. A sales invoice for $5,200 was computed correctly but, by mistake, was entered as $2,500 to the sales journal and posted to the accounts receivable master file. The customer remitted only $2,500, the amount on his monthly statement.

(1) Prelistings and predetermined totals are used to control postings.

(2) Sales invoice numbers, prices, discounts, extensions, and footings are independ- ently checked.

(3) The customers’ monthly statements are verified and mailed by a responsible person other than the bookkeeper who prepared them.

(4) Unauthorized remittance deductions made by customers or other matters in dis- pute are investigated promptly by a person independent of the accounts receivable function.

physical inventory.

(1) Aged trial balance of accounts receivable is prepared.

(2) Credit memoranda are prenumbered and all numbers are accounted for.

(3) Areconciliationofthetrialbalanceofcustomers’accountswiththegeneralledger

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

468

d. Shipments occurring in December 2011 did not get recorded until the first few days of January 2012.

(1) Thesystemautomaticallyassignsbillofladingnumbersandensuresnoduplicates

are issued.

(2) Asgoodsleavetheshippingdock,thesystemgeneratesabillofladingandassoci-

ated sales invoice, which is automatically recorded in the sales journal.

(3) Theaccountingsystemrequiresentryofavalidbillofladingnumberprovidedby

the shipping department before a sales transaction is accepted for entry.

(4) Thesystempreventsthecreationofabillofladingwithoutacustomerorderdated

prior to the shipping date.

14-23 (Objectives 14-1, 14-3) The following questions deal with audit evidence for the sales and collection cycle. Choose the best response.

a. An auditor is performing substantive tests of transactions for sales. One step is to trace a sample of debit entries from the accounts receivable master file back to the sup- porting duplicate sales invoices. What will the auditor intend to establish by this step?

(1) Sales invoices represent existing sales.

(2) All sales have been recorded.

(3) All sales invoices have been correctly posted to customer accounts.

(4) Debit entries in the accounts receivable master file are correctly supported by

sales invoices.

b. To verify that all sales transactions have been recorded, a substantive test of trans-

actions should be completed on a representative sample drawn from

(1) entries in the sales journal.

(2) the billing clerk’s file of sales orders.

(3) a file of duplicate copies of sales invoices for which all prenumbered forms in the

series have been accounted.

(4) the shipping clerk’s file of duplicate copies of bills of lading.

c. Which audit procedure is most effective in testing credit sales for overstatement?

(1) Traceasampleofpostingsfromthesalesjournaltothesalesaccountinthegeneral ledger.

(2) Vouch a sample of recorded sales from the sales journal to shipping documents.

(3) Prepare an aging of accounts receivable.

(4) Trace a sample of initial sales orders to sales recorded in the sales journal.

DISCUSSION QUESTIONS AND PROBLEMS

14-24 (Objectives 14-2, 14-3, 14-4, 14-5) Items 1 through 9 are selected questions of the type generally found in internal control questionnaires used by auditors to obtain an under- standing of internal control in the sales and collection cycle. In using the questionnaire for a client, a “yes” response to a question indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Are customer orders evaluated for credit approval by someone independent of sales? 2. Are online sales automatically recorded in the sales system?

3. Are unit prices obtained from a pre-approved and restricted master file of unit prices? 4. Is the bill of lading information forwarded in a timely fashion to accounting to ensure

recording in the sales journal?

5. Is the numerical sequence of bills of ladings accounted for to identify duplicates or

missing documents?

6. Are entries in the sales journal restricted to those that are supported by a valid bill of

lading?

7. Are sales invoice amounts independently verified for correctness?

8. Are individuals responsible for handling cash collections independent of accounting

and shipping functions?

9. Are entries in the sales journal timely recorded in the accounts receivable master file?

Chapter 14 / AUDIT OF THE SALES AND COLLECTION CYCLE 469

 

Required

a. For each of the preceding questions, state the transaction-related audit objectives being fulfilled if the control is in effect.

b. For each control, list a test of control to test its effectiveness.

c. For each of the preceding questions, identify the nature of the potential financial mis- statements.

d. For each of the potential misstatements in part c, list a substantive audit procedure to determine whether a material misstatement exists.

14-25 (Objectives 14-3, 14-4, 14-5) The following are commonly performed tests of con- trols and substantive tests of transactions audit procedures in the sales and collection cycle:

1. Account for a sequence of shipping documents and examine each one to make sure that a duplicate sales invoice is attached.

2. Account for a sequence of sales invoices and examine each one to make sure that a duplicate copy of the shipping document is attached.

3. Compare the quantity and description of items on shipping documents with the related duplicate sales invoices.

4. Trace recorded sales in the sales journal to the related accounts receivable master file and compare the customer name, date, and amount for each one.

5. Examine sales returns for approval by an authorized official.

6. Review the prelisting of cash receipts to determine whether cash is prelisted daily.

7. Reconcile the recorded cash receipts on the prelisting with the cash receipts journal

and the bank statement for a 1-month period.

a. Identify whether each audit procedure is a test of control or a substantive test of trans- actions.

b. State which of the six transaction-related audit objectives each of the audit procedures fulfills.

Required

Required

and observation.

14-26 (Objective 14-3) The following are selected transaction-related audit objectives and audit procedures for sales transactions:

Transaction-Related Audit Objectives

1. Recorded sales exist.

2. Existing sales are recorded.

3. Sales transactions are correctly included in the accounts receivable master file and

are correctly summarized.

Procedures

1. Trace a sample of shipping documents to related duplicate sales invoices and the sales journal to make sure that the shipment was billed.

2. Examine a sample of duplicate sales invoices to determine whether each one has a shipping document attached.

3. Examine the sales journal for a sample of sales transactions to determine whether each one has a posting reference in the margin indicating that it has been auto- matically compared by the computer with the accounts receivable master file for customer name, date, and amount.

4. Examine a sample of shipping documents to determine whether each one has a duplicate sales invoice number printed on the bottom left corner.

5. Trace a sample of debit entries in the accounts receivable master file to the sales journal to determine whether the date, customer name, and amount are the same.

6. Vouch a sample of duplicate sales invoices to related shipping documents filed in the shipping department to make sure that a shipment was made.

a. For each objective, identify at least one specific misstatement that could occur. b. Describe the differences between the purposes of the first and second objectives.

c. Identify the type of evidence used for each audit procedure, such as documentation

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

470

c. For each audit procedure, identify it as a test of control or substantive test of trans- actions. (There are three of each.)

d. For each objective, identify one test of control and one substantive test of transactions.

e . For each test of control, state the internal control that is being tested. Also, identify or describe a misstatement that the client is trying to prevent by use of the control.

14-27 (Objectives 14-2, 14-3) The following sales procedures were encountered during the annual audit of Marvel Wholesale Distributing Company:

Customer orders are received by the sales order department. A clerk computes the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A com- puter is then used to generate two copies of a sales invoice. The order is filed in the customer order file.

The customer copy of the sales invoice is held in a pending file awaiting notification that the order was shipped. The shipping copy of the sales invoice is routed through the ware- house, and the shipping department has authority for the respective departments to release and ship the merchandise. Shipping department personnel pack the order and manually prepare a three-copy bill of lading: The original copy is mailed to the customer, the second copy is sent with the shipment, and the other is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.

A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared to an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data processing department.

The data processing clerk in accounting enters the sales invoice data into the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.

a. To determine whether the internal controls operated effectively to minimize instances Required

of failure to post invoices to customers’ accounts receivable master file, the auditor would select a sample of transactions from the population represented by the

(1) customerorderfile. (3) customers’accountsreceivablemasterfile. (2) bill of lading file. (4) sales invoice file.

b. To determine whether the internal controls operated effectively to minimize instances of failure to invoice a shipment, the auditor would select a sample of transactions from the population represented by the

(1) customerorderfile. (3) customers’accountsreceivablemasterfile. (2) bill of lading file. (4) sales invoice file.

c. To gather audit evidence that uncollected items in customers’ accounts represented existing trade receivables, the auditor would select a sample of items from the popula- tion represented by the

(1) customerorderfile. (3) customers’accountsreceivablemasterfile. (2) bill of lading file. (4) sales invoice file.*

14-28 (Objectives 14-3, 14-5) The following are common audit procedures for tests of sales and cash receipts:

1. Compare the quantity and description of items on duplicate sales invoices with related shipping documents.

2. Trace recorded cash receipts in the accounts receivable master file to the cash receipts journal and compare the customer name, date, and amount of each one.

3. Examine duplicate sales invoices for an indication that unit selling prices were compared to the approved price list.

4. Examine duplicate sales invoices to determine whether the account classification for sales has been included on the document.

*AICPA adapted.

Chapter 14 / AUDIT OF THE SALES AND COLLECTION CYCLE 471

 

Required

5. Examine the sales journal for related-party transactions, notes receivable, and other unusual items.

6. Select a sample of customer orders and trace the document to related shipping docu- ments, sales invoices, and the accounts receivable master file for comparison of name, date, and amount.

7. Perform a proof of cash receipts.

8. Examine a sample of remittance advices for approval of cash discounts.

9. Account for a numerical sequence of remittance advices and determine whether there

is a cross-reference mark for each one, indicating that it has been recorded in the cash receipts journal.

a. Identify whether each audit procedure is a test of control or substantive test of trans- actions.

b. State which transaction-related audit objective(s) each of the audit procedures fulfills.

c . For each test of control in part a, state a substantive test that could be used to determine whether there was a monetary misstatement.

14-29 (Objective 14-3) The following are a list of possible errors or fraud (1 through 5) involv- ing cash receipts and controls (a through g) that may prevent or detect the errors or fraud:

Possible Errors or Fraud

1. Customer checks are properly credited to customer accounts and are properly deposited, but errors are made in recording receipts in the cash receipts journal.

2. Customer checks are misappropriated before being forwarded to the cashier for deposit.

3. Customer checks are received for less than the customers’ full account balances, but the customers’ full account balances are credited.

4. Customer checks are credited to incorrect customer accounts.

5. Different customer accounts are each credited for the same cash receipt.

Required

For each error or fraud, select one internal control that if properly designed and imple- mented, most likely would be effective in preventing or detecting the errors and fraud. Each response in the list of controls may be used once, more than once, or not at all.*

14-30 (Objective 14-5) You have been asked by the board of trustees of a local church to review its accounting procedures. As part of this review you have prepared the following comments about the collections made at weekly services and record keeping for members’ pledges and contributions:

1. The church’s board of trustees has delegated responsibility for financial management and audit of the financial records to the finance committee. This group prepares the annual budget and approves major cash disbursements but is not involved in collections or record keeping. No audit has been considered necessary in recent years because the same trusted employee has kept church records and served as financial secretary for 15 years.

2. The collection at the weekly service is taken by a team of ushers. The head usher counts the collection in the church office after each service. She then places the collection and a notation of the amount in the church safe. The next morning, the financial secretary opens

*AICPA adapted.

a. b. c.

d. e.

f . g.

Customer orders are compared with an approved customer list. Prenumbered credit memos are used for granting credit for returned goods.

Remittance advices are separated from the checks in the mailroom and forwarded to the accounting department.

The cashier examines each check for proper endorsement.

Total amounts posted to the accounts receivable subsidiary records from remittance advices are compared with the validated bank deposit slip.

Monthly statements are mailed to customers with outstanding balances.

An employee, other than the bookkeeper, periodically prepares a bank reconciliation.

Internal Controls

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

472

the safe and recounts the collection. He withholds about $100 to meet cash expenditures during the coming week and deposits the remainder intact. To facilitate the deposit, members who contribute by check are asked to enter “Cash” on the payee line.

3. At their request, a few members are furnished prenumbered predated envelopes in which to insert their weekly contributions. The head usher removes the cash from the envelopes to be counted with the loose cash included in the collection and discards the envelopes. No record is maintained of issuance or return of the envelopes, and the envelope system is not encouraged.

4. Each member is asked to prepare a contribution pledge card annually. The pledge is regarded as a moral commitment by the member to contribute a stated weekly amount. Some members have inquired about having weekly contributions automatically withdrawn from their bank account or charged to their credit card, but the church has not established procedures that would allow payments other than by cash or check at weekly services. Based on the amounts shown on the pledge cards, the financial secretary furnishes a letter to members, upon request, to support the tax deductibility of their contributions.

Identify the deficiencies and recommend improvements in procedures for collection made at weekly services and record keeping for members’ pledges and contributions. Use the methodology for identifying deficiencies discussed in Chapter 10. Organize your answer sheets as follows:*

Deficiency Recommended Improvement

14-31 (Objectives 14-3, 14-5) Items 1 through 10 present various internal control strengths or internal control deficiencies.

1. Credit is granted by a credit department.

2. Once shipment occurs and is recorded in the sales journal, all shipping documents

are marked “recorded” by the accounting staff.

3. Sales returns are presented to a sales department clerk who prepares a written,

Required

prenumbered receiving report.

4. Cash receipts received in the mail are received by a secretary with no recordkeeping

responsibility.

5. Cash receipts received in the mail are forwarded unopened with remittance advices

to accounting.

6. The cash receipts journal is prepared by the treasurer’s department.

7. Cash is deposited weekly.

8. Statements are sent monthly to customers.

9. Write-offs of accounts receivable are approved by the controller.

10. The bank reconciliation is prepared by individuals independent of cash receipts recordkeeping.

a. For each of the preceding 1–10 items, indicate whether the item represents an:

A. Internal control strength for the sales and collection cycle.

B. Internal control deficiency for the sales and collection cycle.

b. For each item that you answered (A), indicate the transaction-related audit objec- tive(s) to which the control relates.

c. For each item that you answered (B), indicate the nature of the deficiency.*

14-32 (Objective 14-3) YourTeam.com is an online retailer of college and professional sports team memorabilia, such as hats, shirts, pennants and other sports logo products. Consumers select the college or professional team from a pull-down menu on the company’s Web site. For each listed team, the Web site provides a product description, picture, and price for all products sold online. Customers click on the product number of the items they wish to pur- chase. The following are internal controls YourTeam.com has established for its online sales:

1. Only products shown on the Web site can be purchased online. Other company products not shown on the Web site listing are unavailable for online sale.

2. The online sales system is linked to the perpetual inventory system that verifies quan- tities on hand before processing the sale.

Required

*AICPA adapted.

Chapter 14 / AUDIT OF THE SALES AND COLLECTION CYCLE 473

 

474

Required

CASE

3. Before the sale is authorized, YourTeam.com obtains credit card authorization codes electronically from the credit card agency.

4. Online sales are rejected if the customer’s shipping address does not match the credit card’s billing address.

5. Before the sale is finalized, the online screen shows the product name, description, unit price, and total sales price for the online transaction. Customers must click on the Accept or Reject sales buttons to indicate approval or rejection of the online sale.

6. Once customers approve the online sale, the online sales system generates a Pending Sales file, which is an online data file that is used by warehouse personnel to process shipments. Online sales are not recorded in the sales journal until warehouse personnel enter the bill of lading number and date of shipment into the Pending Sales data file.

a. For each control, identify the transaction-related audit objective(s) being fulfilled if each control is in effect.

b. For each control, describe potential financial misstatements that could occur if the control was not present.

14-33 (Objective 14-4) The Meyers Pharmaceutical Company, a drug manufacturer, has the following internal controls for billing and recording accounts receivable:

1. An incoming customer’s purchase order is received in the order department by a clerk who prepares a prenumbered company sales order form on which is inserted the pertinent information, such as the customer’s name and address, customer’s account number, quantity, and items ordered. After the sales order form has been prepared, the customer’s purchase order is attached to it.

2. The sales order form is then passed to the credit department for credit approval. Rough

approximations of the billing values of the orders are made in the credit department for those accounts on which credit limitations are imposed. After investigation, approval of credit is noted on the form.

3. Next, the sales order form is passed to the billing department, where a clerk uses a computer to generate the customer’s invoice. It automatically multiplies the number of items times the unit price and adds the extended amounts for the total amount of the invoice. The billing clerk determines the unit prices for the items from a list of billing prices. The invoice copies are designated as follows:

(a) Customer’scopy.

(b) Sales department copy, for information purposes.

(c) Filecopy.

(d) Shipping department copy, which serves as a shipping order. Bills of lading are also

prepared as carbon copy by-products of the invoicing procedure.

4. The shipping department copy of the invoice and the bills of lading are then sent to the shipping department. After the order has been shipped, copies of the bill of lading are returned to the billing department. The shipping department copy of the invoice is filed in

the shipping department.

5. In the billing department, one copy of the bill of lading is attached to the customer’s

copy of the invoice and both are mailed to the customer. The other copy of the bill of lading, together with the sales order form, is then attached to the invoice file copy and filed in invoice numerical order.

6. As the computer generates invoices, it also stores the transactions in an electronic file that is used to update the accounting records daily. A summary report is generated and all journals and ledgers are printed for a hardcopy of the records.

7. Periodically, an internal auditor traces a sample of sales orders all the way through the system to the journals and ledgers, testing both the procedures and dollar amounts. The procedures include comparing control totals with output, recalculating invoices and refooting journals, and tracing totals to the master file and general ledger.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

a. Flowchart the billing function as a means of understanding the system. Required

b. List the internal controls over sales for each of the six transaction-related audit objectives.

c. For each control, list a useful test of control to verify the effectiveness of the control.

d. For each transaction-related audit objective for sales, list appropriate substantive tests

of transactions audit procedures, considering internal controls.

e. Combine the audit procedures from parts c and d into an efficient audit program for sales.

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART V

14-34 (Objectives 14-3, 14-5) In Part III of this case study, you obtained an understanding of internal control and made an initial assessment of control risk for each transaction- related audit objective for acquisition and cash disbursement transactions. The purpose of Part V is to continue the assessment of control risk by determining the appropriate tests of controls and substantive tests of transactions. In order to do this, you must complete the steps needed to prepare a high-quality performance format audit program for tests of controls and substantive tests of transactions for acquisitions and cash disbursements.

Assume in Part III that you identified the following as the key controls you want to rely on (even though your answers were likely different from these):

1. Segregation of the purchasing, receiving, and cash disbursements functions

2. Use of prenumbered voucher packages, properly accounted for

3. Use of prenumbered checks, properly accounted for

4. Use of prenumbered receiving reports, properly accounted for

5. Internal verification of document package before check preparation

6. Review of supporting documents and signing of checks by an independent, author-

a. Prepare an audit file listing the nine controls or download them from the textbook Required Web site.

b. After each control, identify the transaction-related audit objective(s) that it partially or fully satisfies.

c. Immediately below the control, list one audit procedure to test the control. Use the most reliable test of control evidence that you can think of. Write the audit procedure in good form.

d. Immediately below the test of control, list one substantive test of transactions audit procedure to test whether the control failed to be effective. Use the most reliable sub- stantive tests of transactions evidence that you can think of.

e. Create a separate audit schedule labeled “Acquisitions Substantive Tests of Trans- actions.” Decide and write one substantive test of transactions audit procedure for each transaction-related audit objective for acquisitions. The audit procedures must be different than the ones in requirement d. The schedule should be designed as follows:

Acquisitions Substantive Tests of Transactions

Occurrence Write the substantive audit procedure Completeness Write the substantive audit procedure Etc.

f. Using a separate heading labeled “Cash Disbursements Substantive Tests of Trans- actions,” decide and write one substantive test of transactions audit procedure for each transaction-related audit objective for cash disbursements. The audit procedures must be different than the ones in requirements d and e. The audit schedule should be designed the same as the one in requirement e.

 

ized person

7. Cancellation of documents prior to signing of the check

8. Monthly reconciliation of the accounts payable master file with the general ledger

9. Independent reconciliation of the monthly bank statements

Chapter 14 / AUDIT OF THE SALES AND COLLECTION CYCLE 475

 

 

476

g. Prepare a performance audit program for acquisitions and cash disbursements using all audit procedures in requirements c through f. See Figure 14-6 (p. 462) for a format. To the extent possible, follow the approach in procedure 13 a through e in Figure 14-6 of having “one starting point” procedure followed by other related procedures. Do this for both acquisitions and cash disbursements. Be sure to eliminate any duplicate audit procedures.

ACL PROBLEM

14-35 (Objectives 14-4 and 14-5) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material preceding the instructions for “Quick Sort” before locating the appro- priate command to answer questions a-e. For this problem use the Metaphor_AR_2002 file in ACL_Demo. The suggested command or other source of information needed to solve the problem requirement is included at the end of each question.

a. Determine the total number and amount of September 2002 transactions in the file. (Filter, Count, and Total Field)

b. Determine and print the total amount for each of the five types of 2002 transactions for comparison to the general ledger. (Summarize) Which transaction type has the highest count?

c. For sales invoices (IN), determine the number of transactions, total amount, largest amount and average size. (Filter and Statistics)

d. Determine the number of days difference between the invoice date (DATE1) and the due date (DUE) for sales invoices (IN) and evaluate the internal controls over these two dates. (Computed Field)

 

e. To better decide the sales invoices to select for testing, you decide to stratify 2002 sales

invoices (IN) after excluding all invoices less than $300. Print the output. (Filter and Stratify)

INTERNET PROBLEM 14-1: REVENUE RECOGNITION FRAUD

Required

The Securities and Exchange Commission (SEC) found that Bally Total Fitness Holding Corporation, a nationwide commercial operator of fitness centers, fraudulently accounted for three types of revenues it received from members. The SEC also charged the audit firm and six partners for their roles in the accounting violations. Visit the SEC’s website (www.sec.gov) and search the link to “Litigation Releases” to locate Litigation Release 20470 issued on February 28, 2008 against Bally Total Fitness Holding Corporation to learn more about this revenue fraud.

a. Read the release and the accompanying complaint in this matter and briefly summarize the three types of alleged revenue frauds.

b. Return to the opening page on the SEC’s website and search the link for “Press Releases” to locate the December 17, 2009 announcement of the SEC’s charges against the audit firm and the six partners.

c. Read the press release and briefly summarize the SEC’s description of the nature of audit risk associated with the Bally’s audit engagement.

d. Read the complaint against the audit engagement partner, who served as the 2001 and 2002 engagement partner. What factors caused the audit firm to recognize Bally as a high risk audit client for 1996–2003?

Chapter 15

REVIEW QUESTIONS

15-1 (Objective 15-1) State what is meant by a representative sample and explain its importance in sampling audit populations.

15-2 (Objective 15-2) Explain the major difference between statistical and nonstatistical sampling. What are the three main parts of statistical and nonstatistical methods?

15-3 (Objective 15-3) Explain the difference between replacement sampling and non- replacement sampling. Which method do auditors usually follow? Why?

15-4 (Objective 15-3) What are the two types of simple random sample selection methods? Which of the two methods is used most often by auditors and why?

15-5 (Objective 15-3) Describe systematic sample selection and explain how an auditor will select 40 numbers from a population of 2,800 items using this approach. What are the advantages and disadvantages of systematic sample selection?

15-6 (Objective 15-4) What is the purpose of using nonstatistical sampling for tests of controls and substantive tests of transactions?

15-7 (Objective 15-2) Explain what is meant by block sample selection and describe how an auditor can obtain five blocks of 20 sales invoices from a sales journal.

15-8 (Objective 15-5) Define each of the following terms:

a. Acceptable risk of assessing control risk too low (ARACR) b. Computed upper exception rate (CUER)

c. Estimated population exception rate (EPER)

d. Sample exception rate (SER)

e. Tolerable exception rate (TER)

15-9 (Objective 15-5) Describe what is meant by a sampling unit. Explain why the sampling unit for verifying the occurrence of recorded sales differs from the sampling unit for testing for the possibility of omitted sales.

15-10 (Objective 15-5) Distinguish between the TER and the CUER. How is each deter- mined?

15-11 (Objective 15-1) Distinguish between a sampling error and a nonsampling error. How can each be reduced?

15-12 (Objective 15-4) What is meant by an attribute in sampling for tests of controls and substantive tests of transactions? What is the source of the attributes that the auditor selects?

15-13 (Objective 15-4) Explain the difference between an attribute and an exception condition. State the exception condition for the audit procedure: The duplicate sales invoice has been initialed indicating the performance of internal verification.

15-14 (Objective 15-5) Identify the factors an auditor uses to decide the appropriate TER. Compare the sample size for a TER of 7% with that of 4%, all other factors being equal.

15-15 (Objective 15-5) Identify the factors an auditor uses to decide the appropriate ARACR. Compare the sample size for an ARACR of 10% with that of 5%, all other factors being equal.

Chapter 15 / AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION 509

510

15-16 (Objective 15-5) State the relationship between the following:

a. ARACR and sample size

b. Population size and sample size c. TER and sample size

d. EPER and sample size

15-17 (Objective 15-7) Assume that the auditor has selected 100 sales invoices from a population of 100,000 to test for an indication of internal verification of pricing and extensions. Determine the CUER at a 10% ARACR if four exceptions are found in the sample using attributes sampling. Explain the meaning of the statistical results in auditing terms.

15-18 (Objective 15-5) Explain what is meant by analysis of exceptions and discuss its importance.

15-19 (Objective 15-5) When the CUER exceeds the TER, what courses of action are available to the auditor? Under what circumstances should each of these be followed?

15-20 (Objective 15-3) Distinguish between probabilistic selection and statistical measure- ment. State the circumstances under which one can be used without the other.

15-21 (Objective 15-7) List the major decisions that the auditor must make in using attri- butes sampling. State the most important considerations involved in making each decision.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

15-22 (Objectives 15-5, 15-7) The following items apply to determining sample sizes using random sampling from large populations for attributes sampling. Select the most appropriate response for each question.

a. If all other factors specified in a sampling plan remain constant, changing the ARACR from 5% to 10% will cause the required sample size to

(1) increase.

(2) remain the same.

(3) decrease.

(4) become indeterminate.

b. If all other factors specified in a sampling plan remain constant, changing the TER from 9% to 6% will cause the required sample size to

(1) increase.

(2) remain the same.

(3) decrease.

(4) become indeterminate.

c. Of the four factors that determine the initial sample size in attributes sampling (population size, tolerable exception rate, acceptable risk of assessing control risk too low, and expected population exception rate), which factor has the least effect on sample size?

(1) Population size

(2) Expected population exception rate

(3) Tolerable exception rate

(4) Acceptable risk of assessing control risk too low

d. The sample size of a test of controls varies inversely with:

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

Expected population

deviation rate

No Yes No Yes

Tolerable

exception rate

Yes No No Yes

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

15-23 (Objectives 15-5, 15-7) The following items concern determining exception rates using random sampling from large populations using attributes sampling. Select the best response.

a. From a random sample of items listed from a client’s inventory count, an auditor esti- mates with a 90% confidence level that the CUER is between 4% and 6%. The auditor’s major concern is that there is one chance in ten that the true exception rate in the population is

(1) more than 6%.

(2) less than 6%.

(3) more than 4%.

(4) less than 4%.

b. The upper precision limit (CUER) in statistical sampling is

(1) the percentage of items in a sample that possess a particular attribute.

(2) the percentage of items in a population that possess a particular attribute.

(3) a statistical measure, at a specified confidence level, of the maximum rate of

occurrence of an attribute.

(4) the maximum rate of exception that the auditor would be willing to accept in the

population without altering the planned reliance on the attribute.

c. As a result of tests of controls, an auditor assessed control risk too low and decreased substantive testing. This assessment occurred because the true deviation rate in the population was

(1) less than the risk of assessing control risk too low, based on the auditor’s sample. (2) less than the deviation rate in the auditor’s sample.

(3) morethantheriskofassessingcontrolrisktoolow,basedontheauditor’ssample. (4) more than the deviation rate in the auditor’s sample.

d. An auditor who uses statistical sampling for attributes in testing internal controls

should reduce the planned reliance on a prescribed control when the

(1) sample exception rate plus the allowance for sampling risk equals the tolerable

rate.

(2) sample exception rate is less than the expected rate of exception used in planning

the sample.

(3) tolerableratelesstheallowanceforsamplingriskexceedsthesampleexceptionrate.

(4) sampleexceptionrateplustheallowanceforsamplingriskexceedsthetolerablerate.

15-24 (Objectives 15-1, 15-2) The following questions concern sampling for attributes. Choose the best response.

a. An advantage of statistical sampling over nonstatistical sampling is that statistical sampling helps an auditor

(1) minimize the failure to detect errors and fraud.

(2) eliminate the risk of nonsampling errors.

(3) design more effective audit procedures.

(4) measure the sufficiency of the audit evidence by quantifying sampling risk.

b. Which of the following best illustrates the concept of sampling risk?

(1) The documents related to the chosen sample may not be available to the auditor

for inspection.

(2) An auditor may fail to recognize errors in the documents from the sample.

(3) A randomly chosen sample may not be representative of the population as a

whole for the characteristic of interest.

(4) An auditor may select audit procedures that are not appropriate to achieve the

specific objective.

c. For which of the following tests would an auditor most likely use attribute sampling? (1) Selecting accounts receivable for confirmation of account balances.

(2) Inspecting employee time cards for proper approval by supervisors.

(3) Making an independent estimate of the amount of a LIFO inventory.

(4) Examining invoices in support of the valuation of fixed asset additions.

Chapter 15 / AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION 511

 

512

DISCUSSION QUESTIONS AND PROBLEMS

Required

15-25 (Objective 15-3)

a. In each of the following independent problems, design an unbiased random sampling plan, using an electronic spreadsheet or a random number generator program. The plan should include defining the sampling unit and establishing a numbering system for the population. After the plan has been designed, select the sample using the computer. Assume that the sample size is 75 for each of (1) through (4).

(1) Prenumbered sales invoices in a sales journal where the lowest invoice number is 1 and the highest is 8274.

(2) Prenumberedbillsofladingwherethelowestdocumentnumberis18221andthe highest is 29427.

(3) Accountsreceivableon20pageswith50linesperpageexceptthelastpage,which has only 29 full lines. Each line has a customer name and an amount receivable.

(4) Prenumbered invoices in a sales journal where each month starts over with number 1. (Invoices for each month are designated by the month and document number.) There is a maximum of 25 pages per month with a total of 215 pages for the year. All pages have 100 invoices except for the last page for each month.

b. Using systematic sampling, select the first five sample items for populations (1) through (3) from part a, using the random starting points shown. Recall that the sample size is 75 in each case.

(1) Invoice #39

(2) Bill of lading #18259 (3) Page1,line#11

15-26 (Objectives 15-3, 15-5, 15-7) Lenter Supply Company is a medium-sized distributor

of wholesale hardware supplies in the central Ohio area. It has been a client of yours for

Required

In providing control over shipments, the client has prenumbered “warehouse removal slips” that are used for every sale. It is company policy never to remove goods from the warehouse without an authorized warehouse removal slip. After shipment, two copies of the warehouse removal slip are sent to billing for the computerized preparation of a sales invoice. One copy is stapled to the duplicate copy of a prenumbered sales invoice, and the other copy is filed numerically. In some cases, more than one warehouse removal slip is used for billing one sales invoice. The smallest warehouse removal slip number for the year is 11741 and the largest is 34687. The smallest sales invoice number is 45302 and the largest is 65747.

In the audit of sales, one of the major concerns is the effectiveness of the controls in ensuring that all shipments are billed. You have decided to use audit sampling in testing internal controls.

a. State an effective audit procedure for testing whether shipments have been billed. What is the sampling unit for the audit procedure?

b. Assuming that you expect no exceptions in the sample but are willing to accept a TER of 4%. At a 5% ARACR, what is the appropriate sample size for the audit test? You may complete this requirement using attributes sampling.

c. Design a random selection plan for selecting the sample from the population, using either systematic sampling or computer generation of random numbers. Use the sample size determined in part b. If you use systematic sampling, use a random starting point of 11878.

d. Your supervisor suggests the possibility of performing other sales tests with the same sample as a means of efficiently using your audit time. List two other audit procedures that can conveniently be performed using the same sample and state the purpose of each of the procedures.

e. Is it desirable to test the occurrence of sales with the random sample you have designed in part c? Why?

several years and has instituted excellent internal controls for sales at your recommendation.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

15-27 (Objective 15-7) The following is a partial audit program for the audit of sales transactions.

1. Foot the sales journal for one month and trace the postings to the general ledger.

2. Vouch entries in sales journal to sales invoice and shipping document.

3. Review the sales journal for any large or unusual transactions.

4. Examine evidence on sales invoice that the prices were agreed to the approved price

list.

5. Examine sales order for evidence of credit approval prior to shipment.

6. Recompute extensions of price and quantities on the sales invoice.

a. Identify which audit procedures can be tested by using attributes sampling.

b. What is the appropriate sampling unit for the tests in part a?

c. List the attributes for testing in part a.

d. Assume an ARACR of 5% and a TER of 7% for tests of controls and 5% for substantive tests of transactions. The EPER for tests of controls is 1.5%, and for substantive tests of transactions it is .5%. What is the initial sample size for each attribute?

15-28 (Objectives 15-5, 15-7) The following questions concern the determination of the proper sample size in audit sampling using the following table:

Required

a.

b. c.

d. e.

f .

1234567

ARACR (in percent) 10 5 5 5 10 10 5 TER 665620202 EPER (in percent) 2 2 2 2 8 2 0 Population size 1,000 100,000 6,000 1,000 500 500 1,000,000

Assume that the initial sample size for column 1 using nonstatistical sampling is 90 items. For each of columns 2 through 7, use your judgment to decide the appropriate nonstatistical sample size. In deciding each sample size, consider the effects of changes in each of the four factors (ARACR, TER, EPER, and population size) compared with column 1.

Required

For each of the columns numbered 1 through 7, determine the initial sample size needed to satisfy the auditor’s requirements using attributes sampling from the appropriate part of Table 15-8 (p. 504).

Using your understanding of the relationship between the following factors and sample size, state the effect on the initial sample size (increase or decrease) of changing each of the following factors while the other three are held constant:

(1) AnincreaseinARACR

(2) An increase in the TER

(3) An increase in the EPER

(4) An increase in the population size

Explain why there is such a large difference in the sample sizes for columns 3 and 6.

Compare your answers in part c with the results you determined in part a (nonstatistical sampling) or part b (attributes sampling). Which of the four factors appears to have the greatest effect on the initial sample size? Which one appears to have the least effect?

Why is the sample size called the initial sample size?

15-29 (Objectives 15-5, 15-7) The questions below relate to determining the CUER in audit sampling for tests of controls, using the following table:

ARACR (in percent) Population size Sample size

Number of exceptions

5 5 50,000 500 200 100 4 2

10 5 5,000 5,000 200 200 4 4

5 5 5,000 900 50 100 1 10

5 5 5,000 500 100 25 0 0

12345678

a. Using nonstatistical sampling, calculate TER – SER for each of columns 1 through 8 and evaluate whether or not sampling error is large enough to accept the population. Assume that TER is 5% for each column.

Required

Chapter 15 / AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION 513

 

Required

b. For each of the columns 1 through 8, determine CUER using attributes sampling from the appropriate table.

c. Using your understanding of the relationship between the four preceding factors and the CUER, state the effect on the CUER (increase or decrease) of changing each of the following factors while the other three are held constant:

(1) AdecreaseintheARACR

(2) A decrease in the population size

(3) A decrease in the sample size

(4) A decrease in the number of exceptions in the sample

d. Compare your answers in part c with the results you determined in part a (non- statistical sampling) or part b (attributes sampling). Which of the factors appears to have the greatest effect on the CUER? Which one appears to have the least effect?

e. Why is it necessary to compare the CUER with the TER?

15-30 (Objective 15-7) The following are auditor judgments and attributes sampling results for six populations. Assume large population sizes.

unacceptable? What options are available to the auditor?

d. Why is analysis of the exceptions necessary even when the populations are considered acceptable?

e. For the following terms, identify which is an audit decision, a nonstatistical estimate made by the auditor, a sample result, and a statistical conclusion about the popu- lation:

(1) EPER

(2) TER

(3) ARACR

(4) Actual sample size

(5) Actual number of exceptions in the sample (6) SER

(7) CUER

15-31 (Objectives 15-5, 15-7) The questions below relate to determining the CUER in audit sampling for tests of controls, using the following table:

1234

5 5 5,000 50,000 50 100 2 3 12.1 7.6

a. Calculate SER for each of columns 1 through 4 and use this to calculate the actual allowance for sampling risk.

b. Explain why the CUER is higher for the attribute in column 1 than the attribute in column 2.

123456

EPER (in percent)

TER (in percent)

ARACR (in percent)

Actual sample size

Actual number of exceptions in the sample

2 1 6 5 5 5

100 100 2 4

1 0 3 8 20 3 8 15 10 5 10 10 20 100 60 60

1 0 1 8

Required

a. For each population, did the auditor select a smaller sample size than is indicated by using the attributes sampling tables in Table 15-8 (p. 504) for determining sample size? Evaluate selecting either a larger or smaller size than those determined in the tables.

b. Calculate the SER and CUER for each population.

c. For which of the six populations should the sample results be considered

ARACR (in percent)

Population size

Sample size

Number of exceptions

CUER 10.3 7.9

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

10 10 5,000 50,000 50 100 2 4

514

c. Explain why the CUER higher for the attribute in column 3 than the attribute in column 1.

d. Assume that the TER for attribute 4 is 6 percent. Your audit senior indicates that he would like to be able to rely on this control and has asked you to increase the sample by an additional 50 items. Use the appropriate statistical sampling table to evaluate whether the increase in the sample is likely to result in favorable results for the entire sample of 150 items.

15-32 (Objective 15-5) For the audit of the financial statements of Mercury Fifo Company, Stella Mason, CPA, has decided to apply nonstatistical audit sampling in the tests of controls and substantive tests of transactions for sales transactions. Based on her knowledge of Mercury’s operations in the area of sales, she decides that the EPER is likely to be 3% and that she is willing to accept a 5% risk that the true population exception rate is not greater than 6%. Given this information, Mason selects a random sample of 150 sales invoices from the 5,000 generated during the year and examines them for exceptions. She notes the following exceptions in her audit schedules. There is no other documentation.

Invoice

No. Comment

5028 Sales invoice was originally footed incorrectly but was corrected by client before the bill was sent out.

6791 Voided sales invoice examined by auditor.

6810 Shipping document for a sale of merchandise could not be located.

7364 Sales invoice for $2,875 has not been collected and is 6 months past due.

7625 Client unable to locate the duplicate sales invoice.

8431 Invoice was dated 3 days later than the date entered in the sales journal.

8528 Customer order is not attached to the duplicate sales invoice.

8566 Billing is for $100 less than it should be due to an unintentional pricing error. No indication

of internal verification is included on the invoice.

8780 Client unable to locate the duplicate sales invoice.

9169 Credit not authorized, but the sale was for only $7.65.

9974 Lack of indication of internal verification of price extensions and postings of sales invoice.

a. Which of the preceding should be defined as an exception?

b. Explain why it is inappropriate to set a single acceptable TER and EPER for the

combined exceptions.

c. Calculate SER for each attribute tested in the population. (You must decide which

attributes should be combined, which should be kept separate, and which exceptions

are actual exceptions before you can calculate SER.)

d. Calculate TER – SER for each attribute and evaluate whether sampling error is

sufficiently large given the 5% ARACR. Assume TER is 6% for each attribute.

e. State the appropriate analysis of exceptions for each of the exceptions in the sample,

including additional procedures to be performed.

15-33 (Objectives 15-6, 15-7) The sampling data sheet below is missing selected infor- mation for six attributes involving tests of transactions for the sales and collection cycle.

Required

Attributes

Attribute 1 Attribute 2 Attribute 3 Attribute 4 Attribute 5 Attribute 6

Planned Audit

EPER TER ARACR

0% 6% 5% 0.50% 5% 10% 1% ____ 10% 1% 6% 5% 0% 4% ____ 0.50% 6% 10%

Initial

Sample Sample

Size Size

49 50 ___ 80 55 55 78 80 74 80 64 ___

Actual Results

Number of Exceptions CUER

1 _____ 0 2.9% 1 6.9%

__ 5.8% 0 3.7% 2 7.5%

a. Use Table 15-8 (p. 504) and Table 15-9 (p. 505) to complete the missing information for each attribute.

Required

Chapter 15 / AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION

515

516

b. For which attributes are the sample results unacceptable?

c. Compare attributes 1 and 3. Why does attribute 1 have the smaller sample size? d. Compare attributes 2 and 5. Why is CUER higher for attribute 5?

CASE

Required

a. For which of these procedures can audit sampling for exceptions be conveniently used? b. Considering the audit procedures Wever developed, what is the most appropriate

15-34 (Objectives 15-4, 15-5, 15-7) For the audit of Carbald Supply Company, Carole Wever, CPA, is conducting a test of sales for 9 months of the year ended December 31, 2011. Included among her audit procedures are the following:

1. Foot and cross-foot the sales journal and trace the balance to the general ledger.

2. Review all sales transactions for reasonableness.

3. Select a sample of recorded sales from the sales journal and trace the customer name

and amounts to duplicate sales invoices and the related shipping document.

4. Select a sample of shipping document numbers and perform the following tests:

a. b.

c. d.

e. f .

Trace the shipping document to the related duplicate sales invoice.

Examine the duplicate sales invoice to determine whether copies of the shipping document, shipping order, and customer order are attached.

Examine the shipping order for an authorized credit approval.

Examine the duplicate sales invoice for an indication of internal verification of quantity, price, extensions, footings, and trace the balance to the accounts receivable master file.

Compare the price on the duplicate sales invoice with the approved price list and the quantity with the shipping document.

Trace the balance in the duplicate sales invoice to the sales journal and accounts receivable master file for customer name, amount, and date.

sampling unit for conducting most of the audit sampling tests?

c. Set up a sampling data sheet using attributes or nonstatistical sampling. For all tests of controls, assume a TER rate of 5% and an EPER of 1%. For all substantive tests of transactions, use a 4% TER and a 0% EPER. Use a 10% ARACR for all tests.

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART VI

15-35 (Objectives 15-3, 15-5, 15-7) In Part V of the Pinnacle Manufacturing case, you prepared a performance format audit program. In Part VI, sample sizes will be determined by using nonstatistical or attributes sampling, and the results of the tests will be evaluated. You should use nonstatistical sampling unless your professor tells you to use statistical sampling.

After reviewing the audit program you created in Part V, the audit manager decided to make some modifications. You agreed with her changes. The modified program is included in Figure 15-9.

The audit manager has decided that the tests should be performed for the first 10 months including the month ended 10/31/11. You determine that document numbers are as follows:

Document

Voucher Receiving report Check

Purchase order

First number

6734

9315 12376 3162

Last number

33722 23108 37318 17200

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

FIGURE 15-9 Audit Program for Acquisitions and Cash Disbursements

General

1. Discuss the following items with client personnel and observe activities:

a. Segregation of duties

b. Use of an adequate chart of accounts

c. Monthly reconciliation of accounts payable master file with the general ledger

2. Foot acquisitions and cash disbursements journals for a test month and trace postings to the general ledger.

3. Examine file of completed bank reconciliations.

4. Account for a sequence of cancelled checks.

5. Reconcile recorded cash disbursements with cash disbursements on the bank statement for a test month.

Acquisitions

6. Trace entries in the acquisitions journal to related vendors’ invoices, receiving reports, and purchase orders.

a. Examine indication of internal verification of dates, unit costs, prices, extensions and footings, account classifications, recording in the journal, and posting and summarization.

b. Examine supporting documents for propriety.

c. Compare prices on vendors’ invoices with approved price limits established by management.

d. Recompute information on vendors’ invoices.

e. Examine vendors’ invoices for proper account classification.

f. Compare dates of recorded acquisitions with dates on receiving reports.

g. Examine voucher document package for indication of internal verification.

7. Account for a sequence of purchase orders and voucher document packages.

8. Trace a sample of receiving reports to the acquisitions journal.

Cash Disbursements   9. Select a sample of cancelled checks.

a. Trace cancelled check to the related cash disbursements journal entry and date. b. Examine check for signature, proper endorsement, and cancellation by the bank. c. Compare date on cancelled check with bank cancellation date.

d. Recompute cash discounts.

a. Using the audit program in Figure 15-9, prepare a nonstatistical sampling data sheet Required for acquisitions following the format in Figure 15-2 (p. 490). Prepare all parts of the

sampling data sheet except those that are blank in Figure 15-2. A formatted sampling

data sheet can be downloaded using the Pinnacle link on the textbook Web site. Use

the following guidelines.

(1) Use only one sampling data sheet.

(2) Select the sampling unit that will permit you to perform the most acquisition

audit procedures on the audit program.

(3) Include all audit procedures on the audit program that are consistent with the

sampling unit you selected.

(4) DecideEPER,TER,andARACRforeachattribute.Considerprior-yearresultsfor

EPER. [See Figure 10-12 (p. 333) in Part III.] Use your judgment for the other two

factors.

(5) Decide the sample size for each attribute.

b. Do the same thing for cash disbursements that you did in requirement a for acquisi- tions. You will not complete the actual results portion of the cash disbursements sampling data sheet.

c. For acquisitions only, use an Excel spreadsheet to select random numbers for the largest sample size in the acquisitions sampling data sheet. Include the numbers in

Chapter 15 / AUDIT SAMPLING FOR TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION 517

 

 

518

both random order and sorted numbers, from low to high. Document how you selected the numbers.

d. Assume that you performed all audit procedures included in Figure 15-9 using the sample sizes in requirement a (5). The only exceptions found when you performed the tests include the following: two missing indications of internal verification on a vendor’s invoice, one acquisition of inventory transaction recorded for $2,000 more than the amount stated on the vendor’s invoice (the vendor was also overpaid by $2,000), and two vendors’ invoices recorded as acquisitions several days after the receipt of the goods. Complete the sampling data sheet prepared in requirement a. Use Figure 15-4 (p. 496) as a frame of reference for completing the sampling data sheet.

INTERNET PROBLEM 15-1: APPLYING STATISTICAL SAMPLING

Required

Auditors have used samples to conduct audit tests for decades. Despite the frequent use of sampling, auditors often use nonstatistical sampling rather than statistical sampling. Visit the website for The CPA Journal (www.cpajournal.com) and use the search function to locate the article “Statistical Sampling Revisited” by Neal B. Hitzig, May 2004.

Based on your reading of the article, answer the following questions.

a. What is the primary difference between nonstatistical sampling and statistical sampling?

b. What reasons are often given to support the decision to use nonstatistical sampling versus statistical sampling?

c. What is the main advantage of statistical sampling?

d. Describe what is meant by “probability sampling.”

e. What is the “upper confidence limit” as referred to in the article?

Chapter 16

REVIEW QUESTIONS

16-1 (Objective 16-1) Distinguish among tests of details of balances, tests of controls, and substantive tests of transactions for the sales and collection cycle. Explain how the tests of controls and substantive tests of transactions affect the tests of details of balances.

16-2 (Objective 16-1) Cynthia Roberts, CPA, expresses the following viewpoint: “I do not believe in performing tests of controls and substantive tests of transactions for the sales and collection cycle. As an alternative, I send a lot of negative confirmations on every audit at an interim date. If I find a lot of misstatements, I analyze them to determine their cause. If internal controls are inadequate, I send positive confirmations at year-end to evaluate the amount of misstatements. If the negative confirmations result in minimal misstatements, which is often the case, I have found that the internal controls are effective without bother- ing to perform tests of controls and substantive tests of transactions, and the confirmation requirement has been satisfied at the same time. In my opinion, the best test of internal controls is to go directly to third parties.” Evaluate her point of view.

16-3 (Objective 16-2) List five analytical procedures for the sales and collection cycle. For

each test, describe a misstatement that could be identified.

16-4 (Objective 16-3) Identify the eight accounts receivable balance-related audit objec- tives. For each objective, list one audit procedure.

16-5 (Objective 16-3) Which of the eight accounts receivable balance-related audit objec- tives can be partially satisfied by confirmations with customers?

16-6 (Objective 16-3) State the purpose of footing the total column in the client’s accounts receivable trial balance, tracing individual customer names and amounts to the accounts receivable master file, and tracing the total to the general ledger. Is it necessary to trace each amount to the master file? Why?

16-7 (Objective 16-3) Distinguish between accuracy tests of gross accounts receivable and tests of the realizable value of receivables.

16-8 (Objective 16-3) Explain why you agree or disagree with the following statement: “In most audits, it is more important to test carefully the cutoff for sales than for cash receipts.” Describe how you perform each type of test, assuming documents are prenumbered.

16-9 (Objective 16-4) Evaluate the following statement: “In many audits in which accounts receivable is material, the requirement of confirming customer balances is a waste of time and would not be performed by competent auditors if it were not required by auditing standards. When internal controls are excellent and there are a large number of small receivables from customers who do not recognize the function of confirmation, it is a meaningless procedure. Examples include well-run utilities and retail stores. In these situations, tests of controls and substantive tests of transactions are far more effective than confirmations.”

16-10 (Objective 16-4) Distinguish between a positive and a negative confirmation and state the circumstances in which each should be used. Why do CPA firms sometimes use a combination of positive and negative confirmations on the same audit?

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

Timing difference––a reported dif- ference in a confirmation from a debtor that is determined to be a timing difference between the client’s and

 

542

16-11 (Objective 16-4) Under what circumstances is it acceptable to confirm accounts receivable before the balance sheet date?

16-12 (Objective 16-4) State the most important factors affecting the sample size in confirmations of accounts receivable.

16-13 (Objective 16-4) Discuss whether email responses and oral responses are confir- mations. How can an auditor verify the addresses for confirmations sent by mail, and confirmations sent electronically?

16-14 (Objective 16-4) In Chapter 15, one of the points brought out was the need to obtain a representative sample of the population. How can this concept be reconciled with the statement in this chapter that the emphasis should be on confirming larger and older balances because these are most likely to contain misstatements?

16-15 (Objective 16-4) Define what is meant by alternative procedures in the confirmation of accounts receivable and explain their purpose. Which alternative procedures are the most reliable? Why?

16-16 (Objective 16-4) Explain why the analysis of differences is important in the confirmation of accounts receivable, even if the misstatements in the sample are not material.

16-17 (Objective 16-4) State three types of differences that might be observed in the confirmation of accounts receivable that do not constitute misstatements. For each, state an audit procedure that will verify the difference.

16-18 (Objective 16-1) What is the relationship of each of the following to the sales and collection cycle: flowcharts, assessing control risk, tests of controls, and tests of details of balances?

16-19 (Objective 16-3) Describe accounting requirements for proper recording of sales returns and allowances.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

16-20 (Objective 16-2) The following questions concern analytical procedures in the sales and collection cycle. Choose the best response.

a. As a result of analytical procedures, the auditor determines that the gross profit percentage has declined from 30% in the preceding year to 20% in the current year. The auditor should

(1) expressaqualifiedopinionduetoinabilityoftheclientcompanytocontinueasa

going concern.

(2) evaluate management’s performance in causing this decline.

(3) require footnote disclosure.

(4) consider the possibility of a misstatement in the financial statements.

b. After a CPA has determined that accounts receivable have increased as a result of slow collections in a “tight money” environment, the CPA will be likely to

(1) increase the balance in the allowance for bad debt account.

(2) review the going concern ramifications.

(3) review the credit and collection policy. (4) expand tests of collectibility.

c. In connection with his review of key ratios, the CPA notes that Pyzi had accounts receivable equal to 30 days’ sales at December 31, 2010, and to 45 days’ sales at December 31, 2011. Assuming that there have been no changes in economic conditions, clientele, or sales mix, this change most likely will indicate

(1) a steady increase in sales in 2011.

(2) an easing of credit policies in 2011.

(3) a decrease in accounts receivable relative to sales in 2011. (4) a steady decrease in sales in 2011.

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 543

 

16-21 (Objective 16-4) The following questions deal with confirmation of accounts receivable. Choose the best response.

a. The negative form of accounts receivable confirmation request is useful except when

(1) internal control surrounding accounts receivable is considered to be effective.

(2) a large number of small balances are involved.

(3) the auditor has reason to believe the persons receiving the requests are likely to

give them consideration.

(4) individual account balances are relatively large.

b. The return of a positive confirmation of accounts receivable without an exception attests to the

(1) collectibility of the receivable balance.

(2) accuracy of the receivable balance.

(3) accuracy of the aging of accounts receivable.

(4) accuracy of the allowance for uncollectible accounts.

c. In confirming a client’s accounts receivable in prior years, an auditor found that there were many differences between the recorded account balances and the confirmation responses. These differences, which were not misstatements, required substantial time to resolve. In defining the sampling unit for the current year’s audit, the auditor will most likely choose

(1) individual overdue balances. (3) small account balances. (2) individual invoices. (4) large account balances.

16-22 (Objective 16-3) The following questions concern audit objectives and management assertions for accounts receivable. Choose the best response.

a. When evaluating the adequacy of the allowance for uncollectible accounts, an auditor reviews the entity’s aging of receivables to support management’s balance-related assertion of

(1) existence. (3) valuation and allocation.

(2A) pcoampgleotenesPs. DF Enhance(4r) rights and obligations.

b. Which of the following audit procedures will best uncover an understatement of sales and accounts receivable?

(1) Test a sample of sales transactions, selecting the sample from prenumbered

shipping documents.

(2) Test a sample of sales transactions, selecting the sample from sales invoices

recorded in the sales journal.

(3) Confirm accounts receivable.

(4) Review the aged accounts receivable trial balance.

c. The confirmation of customers’ accounts receivable rarely provides reliable evidence about the completeness assertion because

(1) many customers merely sign and return the confirmation without verifying

details.

(2) recipients usually respond only if they disagree with the information on the

request.

(3) customers may not be inclined to report understatement errors in their accounts.

(4) there is likely to be reliable third party evidence available.

DISCUSSION QUESTIONS AND PROBLEMS

16-23 (Objective 16-3) The following are common tests of details of balances for the audit of accounts receivable:

1. Obtain a list of aged accounts receivable, foot the list, and trace the total to the general ledger.

2. Trace 35 accounts to the accounts receivable master file for name, amount, and age categories.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

544

3. Examine and document cash receipts on accounts receivable for 20 days after the engagement date.

4. Request 25 positive and 65 negative confirmations of accounts receivable.

5. Perform alternative procedures on accounts not responding to second requests by examining subsequent cash receipts documentation and shipping reports or sales

invoices.

6. Test the sales cutoff by tracing entries in the sales journal for 15 days before and after

the balance sheet date to shipping documents, if available, and/or sales invoices.

7. Determine whether any accounts receivable have been pledged, discounted, sold,

assigned, or guaranteed by others.

8. Evaluate the materiality of credit balances in the aged trial balance.

For each audit procedure, identify the balance-related audit objective or objectives it partially or fully satisfies.

16-24 (Objective 16-3) The following misstatements are sometimes found in the sales and collection cycle’s account balances:

1. The accounts receivable trial balance total does not equal the amount in the general ledger.

2. Several accounts receivable in the accounts receivable master file are not included in the aged trial balance.

3. One account receivable in the accounts receivable master file is included on the aged trial balance twice.

4. A shipment made in the subsequent period is recorded as a current period sale.

5. The allowance for uncollectible accounts is inadequate because of the client’s failure

to reflect depressed economic conditions in the allowance.

6. Several accounts receivable are in dispute as a result of claims of defective mer-

Required

chandise.

7. The pledging of accounts receivable to the bank for a loan is not disclosed in the

financial statements.

8. Goods shipped and included in the current period sales were returned in the

subsequent period.

9. Long-term interest-bearing notes receivable from affiliated companies are included

in accounts receivable.

a. For each misstatement, identify the balance-related audit objective to which it pertains.

b. For each misstatement, list an internal control that should prevent it.

c. For each misstatement, list one test of details of balances audit procedure that the auditor can use to detect it.

16-25 (Objective 16-3) The following are audit procedures in the sales and collection cycle:

1. Add the columns on the aged trial balance and compare the total with the general ledger.

2. Examine a sample of shipping documents to determine whether each has a sales invoice number included on it.

3. Examine a sample of customer orders and see if each has a credit authorization.

4. Compare the date on a sample of shipping documents a few days before and after the

balance sheet date with related sales journal transactions.

5. Discuss with the sales manager whether any sales allowances have been granted after

the balance sheet date that may apply to the current period.

6. Observe whether the controller makes an independent comparison of the total in the

general ledger with the trial balance of accounts receivable.

7. Compare the date on a sample of shipping documents throughout the year with

related duplicate sales invoices and the accounts receivable master file.

8. Compute the ratio of allowance for uncollectible accounts divided by accounts

receivable and compare with previous years.

Required

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 545

 

Required

a. For each procedure, identify the applicable type of audit evidence.

b. For each procedure, identify which of the following it is:

(1) Test of control (3) Analytical procedure

(2) Substantive test of transactions (4) Test of details of balances

c. For those procedures you identified as a test of control or substantive test of trans- actions, what transaction-related audit objective or objectives are being satisfied?

d. For those procedures you identified as a test of details of balances, what balance- related audit objective or objectives are being satisfied?

16-26 (Objective 16-3) The following are the eight balance-related audit objectives, six tests of details of balances for accounts receivable, and seven tests of controls or substantive tests of transactions for the sales and collection cycle:

Balance-Related Audit Objective

Detail tie-in Classification Existence Cutoff Completeness Realizable value Accuracy Rights

Test of Details of Balances, Test of Control, or Substantive Test of Transactions Audit Procedure

1. Confirm accounts receivable.

2. Review sales returns after the balance sheet date to determine whether any are

applicable to the current year.

3. Compare dates on shipping documents and the sales journal throughout the year.

4. Perform alternative procedures for nonresponses to confirmation.

5. Examine sales transactions for related party or employee sales recorded as regular sales.

6. Examine duplicate sales invoices for consignment sales and other shipments for

Required

document exists.

9. Examine duplicate sales invoices for initials that indicate internal verification of

extensions and footings.

10. Trace a sample of shipping documents to related sales invoice entries in the sales

journal.

11. Compare amounts and dates on the aged trial balance and accounts receivable

master file.

12. Trace from the sales journal to the accounts receivable master file to make sure the

information is the same.

13. Inquire of management whether there are notes from related parties included with

trade receivables.

a. Identify which procedures are tests of details of balances, which are tests of controls, and which are substantive tests of transactions.

b. For each balance-related audit objective, identify which test of details of balances and test of controls or substantive test of transactions partially satisfy the balance-related objective.

16-27 (Objective 16-3) Niosoki Auto Parts sells new parts for foreign automobiles to auto dealers. Company policy requires that a prenumbered shipping document be issued for each sale. At the time of pickup or shipment, the shipping clerk writes the date on the shipping document. The last shipment made in the fiscal year ended August 31, 2011, was recorded on document 2167. Shipments are billed in the order that the billing clerk receives the shipping documents.

For late August and early September, shipping documents are billed on sales invoices as follows:

which title has not passed.

7. Trace a sample of accounts from the accounts receivable master file to the aged trial

balance.

8. Trace recorded sales transactions to shipping documents to determine whether a

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

546

Shipping Document No.

2163 2164 2165 2166 2167 2168 2169 2170 2171 2172

Sales Invoice No.

5437 5431 5432 5435 5436 5433 5434 5438 5440 5439

The August and September sales journals have the following information included:

Day of Month

30 30 31 31 31

Day of Month

1 1 1 2 2

SALES JOURNAL — AUGUST 2011 Sales Invoice No.

5431 5434 5432 5433 5435

SALES JOURNAL — SEPTEMBER 2011 Sales Invoice No.

5437 5436 5438 5440 5439

Amount of Sale

$ 726.11 4,214.30 419.83 1,620.22 47.74

Amount of Sale

$2,541.31 106.39 852.06 1,250.50 646.58

a. What are the accounting requirements for a correct sales cutoff?

b. Which sales invoices, if any, are recorded in the wrong accounting period? Prepare an

Required

adjusting entry to correct the financial statement for the year ended August 31, 2011. Assume that the company uses a periodic inventory system (inventory and cost of sales do not need to be adjusted).

c. Assume that the shipping clerk accidentally wrote August 31 on shipping documents 2168 through 2172. Explain how that will affect the correctness of the financial statements. How will you, as an auditor, discover that error?

d. Describe, in general terms, the audit procedures you would follow in making sure that cutoff for sales is accurate at the balance sheet date.

e. Identify internal controls that will reduce the likelihood of cutoff misstatements. How would you test each control?

16-28 (Objective 16-4) Dodge, CPA, is auditing the financial statements of a manufacturing company with a significant amount of trade accounts receivable. Dodge is satisfied that the accounts are correctly summarized and classified and that allocations, reclassifications, and valuations are made in accordance with GAAP. Dodge is planning to use accounts receivable confirmation requests to obtain sufficient appropriate evidence as to trade accounts receivable.

a. Identify and describe the two forms of accounts receivable confirmation requests and indicate what factors Dodge will consider in determining when to use each.

b. Assume that Dodge has received a satisfactory response to the confirmation requests. Describe how Dodge can evaluate collectibility of the trade accounts receivable.

c. What are the implications to a CPA if during an audit of accounts receivable some of a client’s trade customers do not respond to a request for positive confirmation of their accounts?

d. What auditing steps should a CPA perform if there is no response to a second request for a positive confirmation?*

*AICPA adapted.

Required

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 547

 

16-29 (Objectives 16-2, 16-3) The Albring Company sells electronics equipment, and has grown rapidly in the last year by adding new customers. The audit partner has asked you to evaluate the allowance for doubtful accounts at December 31, 2011. Comparative information on sales and accounts receivable is included below:

Sales

Accounts Receivable

Allowance for doubtful accounts Bad debt charge-offs

Accounts Receivable: 0–30 days

30–60 days 60–90 days Over 90 days

TOTAL

Year Ended

12/31/11

$ 12,169,876 1,440,381 90,000 114,849

Year Ended

12/31/10

$ 10,452,513 1,030,933 75,000 103,471

$

897,035 254,269 171,846 117,231

$

695,041 160,989 105,997

$ 1,440,381

68,906 $ 1,030,933

Required

a. Identify what tests of controls and substantive tests of transactions you recommend be performed before conducting your analysis of the allowance for doubtful accounts.

b. Perform analytical procedures to evaluate whether the allowance is fairly stated at December 31, 2011. Assume tolerable misstatement for the allowance account is $15,000.

16-30 (Objective 16-4) You have been assigned to the confirmation of aged accounts receivable for the Blank Paper Company audit. You have tested the aged trial balance and selected the accounts for confirming. Before the confirmation requests are mailed, the controller asks to look at the accounts you intend to confirm to determine whether he will permit you to send them.

Required

accounts on your list. Two of them are credit balances, one is a zero balance, two of the other three have a fairly small balance, and the remaining balance is highly material. The reason he gives is that he feels the confirmations will upset these customers because “they are kind of hard to get along with.” He does not want the credit balances confirmed because it may encourage the customer to ask for a refund.

In addition, the controller asks you to send an additional 20 confirmations to customers he has listed for you. He does this as a means of credit collection for “those stupid idiots who won’t know the difference between a CPA and a credit collection agency.”

a. Is it acceptable for the controller to review the list of accounts you intend to confirm? Discuss.

b. Discuss the appropriateness of sending the 20 additional confirmations to the customers.

c. What additional procedures should be performed if the auditor agrees with the client’s request not to send confirmations to the six customers.

16-31 (Objective 16-4) You have been assigned to the first audit of the Chicago Company for the year ending March 31, 2011. Accounts receivable were confirmed on December 31, 2010, and at that date the receivables consisted of approximately 200 accounts with balances totaling $956,750. Fifty of these accounts with balances totaling $650,725 were selected for confirmation. All but 10 of the confirmation requests have been returned; 24 were returned without any exceptions, 6 had minor differences that have been cleared satisfactorily, and 10 confirmations had the following information and comments:

1. We are sorry, but we cannot answer your request for confirmation of our account as the PDQ Company uses an accounts payable voucher system and can only confirm individual invoices.

2. The balance of $1,050 was paid on December 28, 2010. 3. The balance of $7,750 was paid on January 5, 2011.

4. The balance of $2,975 was paid on December 13, 2010.

He reviews the list and informs you that he does not want you to confirm six of the

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

548

5. We do not owe you anything at December 31, 2010, as the goods, represented by your invoice dated December 30, 2010, number 25050, in the amount of $11,550, were received on January 5, 2011, on FOB destination terms.

6. An advance payment of $2,500 made by us in November 2010 should cover the two invoices totaling $1,350 shown on the statement attached.

7. This confirmation was returned as undeliverable by the post office.

8. We are contesting the propriety of this $12,525 charge. We think the charge is excessive.

9. We do not owe this balance as our agreement with the company allows us to return

any unsold goods without penalty. Amount okay. As the goods have been shipped to

us on consignment, we will remit payment upon selling the goods.

10. Your credit memo dated December 5, 2010, in the amount of $440 cancels the

balance above.

a. Indicate which of these confirmation responses likely represent timing differences.

b. Which of the ten confirmation responses likely represent a misstatement? Explain why the response indicates a misstatement.

c. For each of the 10 confirmation responses, indicate the procedures you would perform to determine whether the exception is a misstatement or has been appropriately recorded by the client.*

16-32 (Objectives 16-3, 16-5) The following are various changes in audit circumstances. Audit Circumstance

1. Analytical procedures indicated a significant slowing in accounts receivable turnover.

2. The client entered into sales contracts with new customers that differ from the

client’s standard sales contracts.

3. The client had a significant increase in sales near year-end.

4. Accounts receivable confirmations were ineffective due to a very low response rate in

the prior year audit.

5. The client began experiencing an increase in returns due to product changes that

resulted in increased defects.

6. You found several pricing errors in your substantive tests of transactions for sales.

7. In performing substantive test of transactions for cash receipts, you found that

receipts were promptly recorded in customer accounts, but there were delays in

depositing the receipts at the bank.

8. The client entered into a new loan agreement with the bank. Accounts receivable are

pledged as collateral for the loan.

9. The client did not reconcile the accounts receivable subsidiary records with the

accounts receivable balance in the general ledger on a regular basis.

Match each change in audit circumstance with the most likely test of details of balances response. Each response is used once.

Required

a.

b.

c.

d.

e. f .

g. h.

Expand testing of sales returns after year-end and compare the level of returns with the prior year.

Send positive confirmations that include requests for information on side agreements and special terms.

Increase the number of accounts traced from the accounts receivable trial balance to the accounts receivable subsidiary records.

Expand the review of cash receipts after year-end to evaluate the collectibility of accounts receivable.

Increase the sample size for sales cutoff testing for sales recorded before year-end.

Send a confirmation to the bank confirming amounts pledged as collateral under loan agreements.

Increase the sample size for positive confirmations of accounts receivable.

While at the client’s premises at year-end, obtain information on the last few cash receipt at year-end for cash receipts cutoff testing.

*AICPA adapted.

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 549

Required

 

550

Required

CASE

a. If you are called on to evaluate the adequacy of the sample size, the type of confirma- tion used, and the percent of accounts confirmed, what additional information will you need?

i . Perform alternative procedures to test the existence and accuracy of accounts receivable instead of sending positive confirmations.

16-33 (Objective 16-4) In the confirmation of accounts receivable for the Reliable Service Company, 85 positive and no negative confirmations were mailed to customers. This represents 35% of the dollar balance of the total accounts receivable. Second requests were sent for all nonresponses, but there were still 10 customers who did not respond. The decision was made to perform alternative procedures on the 10 unanswered confirmation requests. An assistant is requested to conduct the alternative procedures and report to the senior auditor after he has completed his tests on two accounts. He prepared the following information for the audit files:

1. Confirmation request no. 9

Customer name—Jolene Milling Co. Balance—$3,621 at December 31, 2011

Subsequent cash receipts per the accounts receivable master file:

2. Confirmation request no. 26

Customer name—Rosenthal Repair Service Balance—$2,500 at December 31, 2011

Subsequent cash receipts per the accounts receivable master file

Sales invoices per the accounts receivable master file (I examined the duplicate invoice)

January 15, 2012—$1,837 January 29, 2012—$1,263 February 6, 2012—$1,429

February 9, 2012—$500

September 1, 2011—$4,200

b. Discuss the need to send second requests and perform alternative procedures for non- responses.

c. Evaluate the adequacy of the alternative procedures used for verifying the two non- responses.

16-34 (Objectives 16-1, 16-3, 16-4, 16-5) You are auditing the sales and collection cycle for the Smalltown Regional Hospital, a small not-for-profit hospital. The hospital has a reputation for excellent medical services and deficient record keeping. The medical people have a tradition of doing all aspects of their job correctly, but because of a shortage of accounting personnel, there is not time for internal verification or careful performance. In previous years, your CPA firm has found quite a few misstatements in billings, cash receipts, and accounts receivable. As in all hospitals, the two largest assets are accounts receivable and property, plant, and equipment.

The hospital has several large loans payable to local banks, and the two banks have told management that they are reluctant to extend more credit, especially considering the modern hospital that is being built in a nearby city. In the past, county taxes have made up deficits, but in the past year, the county has also been incurring deficits because of high unemployment.

In previous years, your response from patients to confirmation requests has been frustrating at best. The response rate has been extremely low, and those who did respond did not know the purpose of the confirmations or their correct outstanding balance. You have had the same experience in confirming receivables at other hospitals.

You conclude that control over cash is excellent and the likelihood of fraud is extremely small. You are less confident about unintentional errors in billing, recording sales, cash receipts, accounts receivable, and bad debts.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

a. Identify the major factors affecting client business risk and acceptable audit risk for Required this audit.

b. What inherent risks are you concerned about?

c. In this audit of the sales and collection cycle, which types of tests are you likely to emphasize?

d. For each of the following, explain whether you plan to emphasize the tests and give reasons:

(1) Tests of controls (3) Analytical procedures

(2) Substantive tests of transactions (4) Tests of details of balances

INTEGRATED CASE APPLICATION — PINNACLE MANUFACTURING: PART VII

16-35 (Objectives 16-2, 16-3, 16-4) Parts III, V, and VI of this case study dealt with obtaining an understanding of internal control and assessing control risk for transactions affecting accounts payable of Pinnacle Manufacturing. In Part VII, you will design analytical procedures and design and perform tests of details of balances for accounts payable.

Assume that your understanding of internal controls over acquisitions and cash disbursements and the related tests of controls and substantive tests of transactions support an assessment of a low control risk. The listing of the 519 accounts making up the accounts payable balance of $12,969,686 at December 31, 2011 is included under the Pinnacle link on the textbook Web site.

a. List those relationships, ratios, and trends that you believe will provide useful infor- Required mation about the overall reasonableness of accounts payable. You should consider

income statement accounts that affect accounts payable in selecting the analytical

procedures.

c. Assume for requirement b that (1) assessed control risk had been high rather than low for each transaction-related audit objective, (2) inherent risk was high for each balance-related audit objective, and (3) analytical procedures indicated a high potential for misstatement. What would the effect have been on the audit procedures and sample sizes for requirement b?

d. Confirmation requests were sent to a stratified sample of 51 vendors listed in Figure 16-8 (p. 552). Confirmation responses from 45 vendors were returned indicating no difference between the vendor’s and the company’s records. Figure 16-9 (pp. 553–554) presents the six replies that indicate a difference between the vendor’s balance and the company’s records. The auditor’s follow-up findings are indicated on each reply. Prepare an audit schedule similar to the one illustrated in Figure 16-10 (p. 555) to determine the misstatements, if any, for each difference. The audit schedule format shown in Figure 16-10 can be downloaded using the Pinnacle link on the textbook Web site. The exception for Fiberchem is analyzed as an illustration. Assume that Pinnacle Manufacturing took a complete physical inventory at December 31, 2011, and the auditor concluded that recorded inventory reflects all inventory on hand at the balance sheet date. Include the balances confirmed without exception as one amount on the schedule for each stratum, and total the schedule columns.

e. Estimate the total misstatement in the income statement, not just the misstatements in the sample, based on the income statement misstatements you identified in requirement d. The total misstatement should include a projected misstatement and an estimate for sampling error. Hint: See pages 257–258 for guidance on calculating

 

b. Study Table 19-5 (p. 647) containing balance-related audit objectives and tests of details of balances for accounts payable to be sure you understand each procedure and its purpose. Prepare an audit program for accounts payable in a performance format, using the audit procedures in Table 19-5. The format of the audit program should be similar to Table 16-5 (p. 541). Be sure to include a sample size for each procedure.

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 551

 

FIGURE 16-8 Pinnacle Manufacturing Sample of Accounts Payable Selected for Confirmation — December 31, 2011

High-Volume Items (>$250,000)

1. American Press

2. Clean-O-Rama, Co.

3. Fiberchem

4. Rufus Austin Antiques 5. Todd Machinery

6. Welburn Manufacturing

Large Balance Items ($50,001–$250,000)

1. A & M Sandler Inc.

2. American Baby/USTC

3. Beach & Hoover Refining 4. Bearing Drives Co.

5. Burton Martin

6. Cable Sys./Ind. Traf. Cons. 7. Eddie Ventura, Inc.

8. Fiberoptics

9. Finish Metals Inc.

10. Freeman Furniture–Attn A/P 11. GP Chambers Co.

12. Godwin Drug Co.

13. Holy Family Hospital

14. Las Flores Designs Inc.

15. Lean Corp.

16. MacDonald Svc. Corporation 17. McCoys Inc.

18. Metadyne Corp.

19. Micron Power Systems

20. Mobil Oil

21. National Elevator & Mach. Co. 22. Norris Industries

$ 340,767.94 317,668.63 793,049.89 400,046.08 531,073.93 388,836.07

$2,771,442.54

23. R & B Products

24. Remington Supply

25. Safety Envelope Co.

26. Scandec USA Inc.

27. The Dutton Company 28. The Haberdashery Co. 29. University of California 30. ZZZZ Bank Adjustments

Items $50,000 and less

1. Advent Sign Mfg. Co.

2. B&K Mfg. Co. Inc.

3. Bellco

4. Boston Shoecase Co.

5. Dynamic Metal Products 6. Everhart Co.

7. Fuller Travel

8. Good House Home Video Inc. 9. Harrah’s Metals, Inc.

10. J C Licht Co.—Glendale Hts. 11. Liberty Lighting

12. Long Beach Lawn Service 13. Premier Whirlpool Bath

14. Quaker Transanalysis 15. Tower International

TOTAL TESTED

$2,660,878.80

$

81,348.54 75,432.73 76,408.79 73,017.24 78,682.54 71,288.95 60,255.55 60,102.78 60,769.71

130,493.51 64,125.44 84,331.05

117,916.83 88,644.92 67,985.23

147,943.95 67,936.32 85,432.51

136,071.37 93,210.48 76,921.40 88,314.64 80,092.46

123,411.24 223,950.34 65,942.94 63,882.02 71,869.16 80,624.95 64,471.21

51,750.00 42,668.50 42,710.74 52,174.50 36,546.05 47,519.14 32,470.11 46,472.67 51,279.85 53,228.47 46,802.78 48,488.96

6,550.33 50,363.69 37,299.55

$

$ 646,325.34

$6,078,646.68

the point estimate. Note that the misstatements should be projected separately for each stratum. You will need to determine the size of each stratum using the accounts payable listing. Use your judgment to estimate sampling error, considering the size of the population and the amounts tested.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

552

f . Estimate the total misstatement in accounts payable in the same way you did for the income statement in requirement e. Hint: A misstatement caused by the failure to record an FOB origin purchase is an understatement of accounts payable and inven- tory and has no effect on income.

g. What is your conclusion about the fairness of the recorded balance in accounts payable for Pinnacle Manufacturing as it affects the income statement and balance sheet? How does this affect your assessment of control risk as being low for all transaction-related audit objectives? Assume you decided that tolerable misstatement for accounts payable as it affects the income statement is $250,000.

FIGURE 16-9 Replies to Requests for Information

STATEMENT FROM FIBERCHEM

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

Invoice No.

8312

8469

8819

9002

Date

11-22-11 12-02-11 12-18-11 12-30-11

Amount

$300,000.00 178,000.00 315,049.89

32,500.00(2)

Balance Due

$300,000.00 478,000.00 793,049.89(1) 825,549.89

Auditor’s notes:

(1) Agrees with accounts payable listing.

(2) Goods shipped FOB Fiberchem’s plant on December 31, 2011;

arrived at Pinnacle Manufacturing on January 4, 2012.

STATEMENT FROM MOBIL OIL

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

Invoice No.

DX14777 DX16908

Date

12-23-11 12-29-11

Amount

$93,210.48 37,812.00(2)

Balance Due

$ 93,210.48(1) 131,022.48

Auditor’s notes:

(1) Agrees with accounts payable listing.

(2) Goods shipped FOB Pinnacle Manufacturing on December 29, 2011;

arrived at Pinnacle Manufacturing on January 3, 2012.

STATEMENT FROM NORRIS INDUSTRIES

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

Invoice No.

14896 15111

Date

12-27-11 12-28-11

Amount

$ 88,314.64 117,296.00(2)

Balance Due

$ 88,314.64(1) 205,610.64

Auditor’s notes:

(1) Agrees with accounts payable listing.

(2) Goods received December 30, 2011; recorded on January 2, 2012.

(Figure 16-9 continued on next page)

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 553

 

FIGURE 16-9 Replies to Requests for Information (Cont.)

STATEMENT FROM REMINGTON SUPPLY

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

Invoice No. Date Amount

Balance Due

$ 23,067.00 35,067.00 42,167.00 69,882.24

123,411.24(1)

141702

142619

142811

143600

144927

11-11-11 $23,067.00 11-19-11 12,000.00 12-04-11 7,100.00 12-21-11 27,715.24 12-29-11(2) 53,529.00

Auditor’s notes:

(1) Agrees with accounts payable listing.

(2) Goods shipped FOB Pinnacle Manufacturing on December 29, 2011; arrived at

Pinnacle Manufacturing on January 4, 2012.

STATEMENT FROM ADVENT SIGN MFG. CO.

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

First progress billing per contract Second progress billing per contract

Total due

$51,750.00(1) 7,500.00(2)

$59,250.00

AuAditpor’sanogteso:   Enhancer

(1) Agrees with accounts payable listing.

(2) Progress payment due as of December 31, 2011, per contract for construction

of new custom electric sign; sign installation completed on January 15, 2012.

STATEMENT FROM FULLER TRAVEL

Pinnacle Manufacturing Detroit, MI

Amounts due as of December 31, 2011:

Invoice No.

84360110

84360181

84360222

84360291

Date

12-04-11 12-12-11 12-21-11 12-26-11

Amount

$9,411.63(2) 9,411.63(2) 7,100.00(1)

13,646.85(2)

Balance Due

$ 9,411.63 18,823.26 25,923.26 39,570.11

Auditor’s notes:

(1) Paid by Pinnacle Manufacturing on December 28, 2011; payment in transit at year-end. (2) The total of these items of $32,470.11 agrees with accounts payable listing.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

554

FIGURE 16-10 Pinnacle Manufacturing Analysis of Trade Accounts Payable — December 31, 2011 Misstatement in

Vendor

Balance Amount per Confirmed Books by Vendor

Books Over (Under) Amount Confirmed

Timing Difference: No Misstatement

Related Accounts

Misstatement Other Balance Income in Accounts Sheet Statement

Payable Misstatement Misstatement o/s (u/s)* o/s (u/s)* o/s (u/s)*

Brief Explanation

Key Accounts (>$250,000)

Fiberchem

$793,049.89

$825,549.89

$(32,500.00)

$(32,500.00)

$(32,500.00)

F.O.B. Origin error:

Dr. Inv.

Cr. A/P

Accounts in stratum $50,001–$250,000

Accounts in stratum less than or equal to $50,000

Enhancer

* o/s = overstatement u/s = understatement

Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE

555

 

556

ACL PROBLEM

16-36 (Objective 16-3) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material preceding the instructions for “Quick Sort” before locating the appropriate command to answer questions a-f. For this problem use the Metaphor_Trans_All file in ACL Demo, which is a file of outstanding sales invoices (each row represents an invoice transaction). The suggested command or other source of information needed to solve the problem requirement is included at the end of each question.

a. Determine the total number of invoices (read the bottom of the Metaphor_Trans_All file screen) and total unpaid invoices outstanding (NEWBAL) for comparison to the general ledger. (Total Field)

b. How many of the invoices included a finance charge (FINCHG) and what was the total amount of the finance charges? (Filter, Count Records, and Total Field)

c. Determine and print accounts receivable outstanding from each customer and total the amount for comparison to part a (Note: remove the filter from step b first). (Summarize and Total Field) Which customer number has the largest balance due?

d. What is the largest and smallest account balance outstanding? (Quick Sort)

e. For the account with the largest balance, prepare and print an aging of the account from the transaction file using the statement date labeled “STMTTDT.” Use the aging date as of 4/30/2003 and “NEWBAL” as the subtotal field. (Filter and Age)

f. To better decide the customers to select for confirmation you decide to stratify customer balances into two intervals after excluding all balances less than $5,000. How many balances are greater than $5,000? Print the output. (Filter and Stratify)

INTERNET PROBLEM 16-1: REVENUE RECOGNITION

Required

In recent years, several high-profile incidents of improper revenue recognition attracted the attention of the business media. The SEC has also expressed concerns about the number of instances of improper revenue recognition identified by SEC staff. One revenue issue involves “bill and hold” sales. In a bill and hold transaction, a customer agrees to purchase the goods, but the seller retains physical possession until the customer requests shipment to designated locations. Normally, such an arrangement does not qualify as a sale because delivery has not occurred. Under certain conditions, however, when a buyer has made a firm purchase commitment and has assumed the risks and rewards of the purchased product, but is unable to accept delivery because of a compelling business reason, bill and hold sales may qualify for revenue recognition. Read the SEC guidance on revenue recognition (www.sec.gov/interps/account/sabcodet13.htm) to answer the following questions:

a. What does the SEC indicate are the four basic criteria for determining whether revenue is realized or realizable?

b. A customer of your audit client, Henson LLC, made a formal written request to establish a bill and hold arrangement in November 2011, an arrangement which is typical in the industry. The customer’s written request outlines a delivery schedule that will begin in February 2012. As of November 2011, the product to be shipped in February is already complete and ready for shipment. Because the sale was completed in 2011, your audit client would like to record the bill and hold the transaction described as a sale in 2011. You do not recall noticing any inventory held in a separate area of the client’s warehouse during the December 31, 2011 inventory observation. In making your determination regarding the timing of the revenue recognition, what criteria has the SEC determined to be important?

Chapter 17

REVIEW QUESTIONS

Ratio estimation—a method of variables sampling in which the auditor estimates the population misstatement by multi- plying the portion of sample dollars misstated by the total recorded popu- lation book value and also calculates sampling risk

Statistical inferences—statistical conclu- sions that the auditor draws from sample results based on knowledge of sampling distributions

Stratified sampling—a method of sampling in which all the elements in the total population are divided into two or more subpopulations that are indepen- dently tested and statistically measured

Variables sampling—sampling techniques for tests of details of balances that use the statistical inference process

17-1 (Objective 17-1) What major difference between (a) tests of controls and substantive tests of transactions and (b) tests of details of balances makes attributes sampling inappro- priate for tests of details of balances?

17-2 (Objective 17-2) Define stratified sampling and explain its importance in auditing. How can an auditor obtain a stratified sample of 30 items from each of three strata in the confirmation of accounts receivable?

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

17-3 (Objective 17-2) Distinguish between the point estimate of the total misstatements and the true value of the misstatements in the population. How can each be determined?

17-4 (Objective 17-2) Evaluate the following statement made by an auditor: “On every aspect of the audit where it is possible, I calculate the point estimate of the misstatements and evaluate whether the amount is material. If it is, I investigate the cause and continue to test the population until I determine whether there is a serious problem. The use of statistical sampling in this manner is a valuable audit tool.”

17-5 (Objective 17-3) Define monetary unit sampling and explain its importance in auditing. How does it combine the features of attributes and variables sampling?

17-6 (Objectives 17-1, 17-2, 17-3, 17-4) Define what is meant by sampling risk. Does sampling risk apply to nonstatistical sampling, MUS, attributes sampling, and variables sampling? Explain.

17-7 (Objectives 17-1, 17-2) What are the major differences in the 14 steps used in nonstatistical sampling for tests of details of balances versus for tests of controls and sub- stantive tests of transactions?

17-8 (Objective 17-3) The 2,620 inventory items described in Question 17-14 are listed on 44 inventory pages with 60 lines per page. There is a total for each page. The client’s data are not in machine-readable form. Describe how a monetary unit sample can be selected in this situation.

17-9 (Objective 17-3) Explain how the auditor determines tolerable misstatement for MUS. 17-10 (Objective 17-2) Explain what is meant by acceptable risk of incorrect acceptance.

What are the major audit factors affecting ARIA?

17-11 (Objective 17-4) Evaluate the following statement made by an auditor: “I took a random sample and derived a 90 percent confidence interval of $800,000 to $900,000. That means that the true population value will be between $800,000 and $900,000, 90 percent of the time.”

17-12 (Objective 17-2) What is the relationship between ARIA and ARACR?

17-13 (Objective 17-3) What is meant by the “percent of misstatement assumption” for MUS in those population items that are misstated? Why is it common to use a 100% misstatement assumption when it is almost certain to be highly conservative?

17-14 (Objective 17-3) An auditor is determining the appropriate sample size for testing inventory valuation using MUS. The population has 2,620 inventory items valued at $12,625,000. The tolerable misstatement for both understatements and overstatements is $500,000 at a 10% ARIA. No misstatements are expected in the population. Calculate the preliminary sample size using a 100% average misstatement assumption.

17-15 (Objective 17-5) Assume that a sample of 100 units was obtained in sampling the inventory in Question 17-14. Assume further that the following three misstatements were found:

Misstatement

1 2 3

Recorded Value

$ 897.16 47.02 1,621.68

Audited Value

$ 609.16 0 1,522.68

Calculate adjusted misstatement bounds for the population. Draw audit conclusions based on the results.

17-16 (Objective 17-3) Why is it difficult to determine the appropriate sample size for MUS? How should the auditor determine the proper sample size?

17-17 (Objective 17-5) What is meant by a decision rule using difference estimation? State the decision rule.

17-18 (Objective 17-2) What alternative courses of action are appropriate when a popu- lation is rejected using nonstatistical sampling for tests of details of balances? When should each option be followed?

Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES

591

592

17-19 (Objective 17-4) Define what is meant by the population standard deviation and explain its importance in variables sampling. What is the relationship between the population standard deviation and the required sample size?

17-20 (Objective 17-5) In using difference estimation, an auditor took a random sample of 100 inventory items from a large population to test for proper pricing. Several of the inven- tory items were misstated, but the combined net amount of the sample misstatement was not material. In addition, a review of the individual misstatements indicated that no misstatement was by itself material. As a result, the auditor did not investigate the misstatements or make a statistical evaluation. Explain why this practice is improper.

17-21 (Objectives 17-3, 17-4) Distinguish among difference estimation, ratio estimation, mean-per-unit estimation, and stratified mean-per-unit estimation. Give one example in which each can be used. When is MUS preferable to any of these?

17-22 (Objective 17-4) An essential step in difference estimation is the comparison of each computed confidence limit with tolerable misstatement. Why is this step so important, and what should the auditor do if one of the confidence limits is larger than the tolerable misstatement?

17-23 (Objective 17-4) Explain why difference estimation is commonly used by auditors. 17-24 (Objectives 17-3, 17-4) Give an example of the use of attributes sampling, MUS, and

variables sampling in the form of an audit conclusion.

MULTIPLE CHOICE QUESTIONS FROM CPA AND CIA EXAMINATIONS

17-25 (Objective 17-2) The following questions relate to determining sample size in tests of details of balances. For each one, select the best response.

a. Mr. Murray decides to use stratified sampling. The reason for using stratified sampling rather than unrestricted random sampling is to

(1) reduce as much as possible the degree of variability in the overall population.

(2) give every element in the population an equal chance of being included in the

sample.

(3) allow the person selecting the sample to use personal judgment in deciding which

elements should be included in the sample.

(4) allow the auditor to emphasize larger items from the population.

b. Which of the following sample planning factors will influence the sample size for a test of details of balances for a specific account?

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

Expected Amount

of Misstatements

No Yes No Yes

Measure of

Tolerable Misstatement

No Yes Yes No

c. How would increases in tolerable misstatement and assessed level of control risk affect the sample size in substantive tests of details?

Increase in Tolerable Misstatement

(1) Increase sample size (2) Increase sample size (3) Decrease sample size (4) Decrease sample size

Increase in Assessed Level of Control Risk

Increase sample size Decrease sample size Increase sample size Decrease sample size

17-26 (Objective 17-2) The following apply to evaluating results of audit sampling for tests of details of balances. For each one, select the best response.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

a. While performing a substantive test of details during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was materially misstated. It was, in fact, not materially misstated. This situation illustrates the risk of

(1) assessing control risk too high. (3) incorrect rejection. (2) assessing control risk too low. (4) incorrect acceptance.

b. Which of the following is true regarding two random samples drawn in the same way from the same population, one of size 30 and the other of size 300?

(1) The two samples would have the same expected value.

(2) The larger sample is more likely to produce a larger sample mean.

(3) The smaller sample will have a 95% confidence interval for the mean.

(4) The smaller sample will, on average, produce a lower estimate of the variance of

the population.

c. The accounting department reports the accounts receivable balance as $175,000. You

are willing to accept that balance if it is within $15,000 of the actual balance. Using a variables sampling plan, you compute a 95% confidence interval of $173,000 to $187,000. You would therefore

(1) find it impossible to determine the acceptability of the balance.

(2) accept the balance but with a lower level of confidence.

(3) take a larger sample before rejecting the sample and requiring adjustments.

(4) acceptthe$175,000balancebecausetheconfidenceintervaliswithinthemateriality

limits.

17-27 (Objectives 17-3, 17-4, 17-5) The following relate to the use of statistical sampling for tests of details of balances. For each one, select the best response.

a. When the auditor uses monetary unit statistical sampling to examine the total dollar value of invoices, each invoice

(1) has an equal probability of being selected.

(2) can be represented by no more than one monetary unit.

(3) has an unknown probability of being selected.

(4) has a probability proportional to its dollar value of being selected.

b. Which of the following would be an advantage of using variables sampling rather than

probability-proportional-to-size (PPS) sampling?

(1) An estimate of the standard deviation of the population’s recorded amount is not

required.

(2) The auditor rarely needs the assistance of a computer program to design an

efficient sample.

(3) Theinclusionofzeroandnegativebalancesusuallydoesnotrequirespecialdesign

considerations.

(4) Anyamountthatisindividuallysignificantisautomaticallyidentifiedandselected.

c. In applying variables sampling, an auditor attempts to

(1) estimate a qualitative characteristic of interest.

(2) determine various rates of occurrence for specified attributes. (3) discover at least one instance of a critical deviation.

(4) predict a monetary population value within a range of precision.

DISCUSSION QUESTIONS AND PROBLEMS

17-28 (Objective 17-2) You are planning to use nonstatistical sampling to evaluate the results of accounts receivable confirmation for the Meridian Company. You have already performed tests of controls for sales, sales returns and allowances, and cash receipts, and they are considered excellent. Because of the quality of the controls, you decide to use an acceptable risk of incorrect acceptance of 10%. There are 3,000 accounts receivable with a gross value of $6,900,000. The accounts are similar in size and will be treated as a single stratum. An overstatement or understatement of more than $150,000 is considered material.

Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 593

594

Required

a. Calculate the required sample size. Assume your firm uses the following nonstatistical formula to determine sample size:

Sample size = (Book value of population / Tolerable misstatement) x Assurance factor

An assurance factor of 2 is used for a 10% ARIA.

b. Assume that instead of good results, poor results were obtained for tests of controls and substantive tests of transactions for sales, sales returns and allowances, and cash receipts. How will this affect your required sample size? How will you use this information in your sample size determination?

c. Regardless of your answer to part a, assume you decide to select a sample of 100 accounts for testing. Indicate how you will select the accounts for testing using systematic selection.

d. Assume a total book value of $230,000 for the 100 accounts selected for testing. You uncover three overstatements totaling $1,500 in the sample. Evaluate whether the population is fairly stated.

17-29 (Objective 17-2) You are evaluating the results of a nonstatistical sample of 85 accounts receivable confirmations for the Bohrer Company. Information on the sample and population are included below. An overstatement or understatement of more than $100,000 is considered material.

# of

Stratum Accounts

1 > $75,000 8

2 $10,000 – $74,999 40

3 < $10,000 25

Recorded

Value

$1,287,643 1,349,678

94,637 __________

$2,731,958

# of

Accounts

8

257

712 ____

977

Recorded

Value

$1,287,643 4,348,268

947,682 __________

$6,583,593

Sample _______________________

Population _______________________

___ 73

The confirmation responses were received without exception, other than the following items:

Acct. No.

147 228

278 497

564 653

830

Recorded Value

$ 24,692 183,219

7,546

15,319

8,397 32,687

5,286

Confirmation Response

$ 23,597 157,216

5,546 0

7,858 19,328

0

Auditor Follow-up

Customer was charged the wrong price. $26,003 shipment recorded on December 30th;

goods were not shipped until January 3rd. Customer sent $2,000 payment on December 29th;

received on January 2nd.

$17,443 shipment recorded on December 30th;

goods were not shipped until January 2nd. Customer received less than the full quantity ordered. $13,359 shipment recorded on December 30th;

goods were not shipped until January 2nd. $5,286 shipment made December 30th;

goods were received by the customer on January 4th.

Required

a. Evaluate each of the confirmation exceptions to determine whether they represent misstatements.

b. Estimate the total amount of misstatement in the accounts receivable population. Ignore sampling risk in the calculation.

c. Is the population acceptable? If not, indicate what follow-up action(s) you consider appropriate in the circumstances.

17-30 (Objective 17-3) The accounts receivable population for Jake’s Bookbinding Company follows. This table is the same as Table 17-1 on page 560, except that cumulative amounts are included to assist you in completing the problem. The population is smaller than is ordinarily the case for statistical sampling, but an entire population is useful to show how to select PPS samples.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

a. Select a random PPS sample of 10 items, using computer software.

b. Select a sample of 10 items using systematic PPS sampling using the same concepts dis- cussed in Chapter 15 for systematic sampling. Use a starting point of 1857. Identify the physical units associated with the sample dollars. (Hint: The interval is 207,295 ÷ 10.)

c. Which sample items will always be included in the systematic PPS sample regardless of the starting point? Will that also be true of random PPS sampling?

Required

d. Which method is preferable in terms of ease of selection in this case?

e. Why will an auditor use MUS?

Population

Item

1 2 3 4 5 6 7 8 9

10

11

12

13

14

15

16

17

18

19

20

Recorded

Amount

$ 1,410 9,130 660 3,355 5,725 8,210 580 44,110 825 1,155 2,270 50 5,785 940 1,820 3,380 530 955 4,490 17,140

Cumulative

Amount

$ 1,410 10,540 11,200 14,555 20,280 28,490 29,070 73,180 74,005 75,160 77,430 77,480 83,265 84,205 86,025 89,405 89,935 90,890 95,380

Population

Item (cont.)

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

Recorded

Amount (cont.)

$

Cumulative

Amount (cont.)

$117,385 118,155 120,460 123,125 124,125 130,350 134,025 140,275 142,165 169,870 170,805 176,400 177,330 181,375 190,855 191,215 192,360 198,760 198,860

 

112,520 40 8,435 207,295

4,865 770 2,305 2,665 1,000 6,225 3,675 6,250 1,890 27,705 935 5,595 930 4,045 9,480 360 1,145 6,400 100

17-31 (Objective 17-3) In the audit of Price Seed Company for the year ended September 30, the auditor set a tolerable misstatement of $50,000 at an ARIA of 10%. A PPS sample of 100 was selected from an accounts receivable population that had a recorded balance of $1,975,000. The following table shows the differences uncovered in the confirmation process:

Accounts Accounts Receivable Receivable per

per Records Confirmation

1. $ 2,728.00 $ 2,498.00

2. $ 5,125.00 -0-

3. $ 3,890.00 $ 1,190.00

4. $ 791.00 $ 815.00

5. $ 548.00 $ 1,037.00

6. $ 3,115.00 $ 3,190.00

7. $ 1,540.00 -0-

Follow-up Comments by Auditor

Pricing error on two invoices.

Customer mailed check 9/26; company received check 10/3. Merchandise returned 9/30 and counted in inventory; credit

was issued 10/6.

Footing error on an invoice.

Goods were shipped 9/28; sale was recorded on 10/6. Pricing error on a credit memorandum.

Goods were shipped on 9/29; customer received goods 10/3;

sale was recorded on 9/30.

a. Calculate the upper and lower misstatement bounds on the basis of the client mis- statements in the sample.

b. Is the population acceptable as stated? If not, what options are available to the auditor at this point? Which option should the auditor select? Explain.

17-32 (Objective 17-3) You intend to use MUS as a part of the audit of several accounts for Roynpower Manufacturing Company. You have done the audit for the past several years, and there has rarely been an adjusting entry of any kind. Your audit tests of all tests of controls and substantive tests of transactions cycles were completed at an interim date, and control risk has been assessed as low. You therefore decide to use an ARIA of 10% and an

Required

Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 595

596

Required

a. b. c .

d. e.

Evaluate the audit approach of testing all three account balances in one sample.

Calculate the required sample size for all three accounts.

Calculate the required sample size for each of the three accounts, assuming you decide that the tolerable misstatement in each account is $100,000. (Recall that tolerable misstatement equals preliminary judgment about materiality for MUS.)

Assume that you select the random sample using computer software. How will you identify which sample item in the population to audit for the number 4,627,871? What audit procedures will be performed?

EPER of 0% for all tests of details of balances. You also decide to use a 100% misstatement assumption for both overstatements and understatements.

You intend to use MUS in the audit of the three most material asset balance sheet account balances: accounts receivable, inventory, and marketable securities. You feel justi- fied in using the same ARIA for each audit area because of the low assessed control risk.

The recorded balances and related information for the three accounts are as follows:

Accounts receivable Inventory

Marketable securities

Recorded Value

$ 3,600,000

4,800,000

1,600,000 _____________

$ 10,000,000

Net earnings before taxes for Roynpower are $2,000,000. You decide that a combined misstatement of $100,000 is allowable for the client.

The audit approach to be followed will be to determine the total sample size needed for all three accounts. A sample will be selected from all $10 million, and the appropriate testing for a sample item will depend on whether the item is a receivable, inventory, or marketable security. The audit conclusions will pertain to the entire $10 million, and no conclusion will be made about the three individual accounts unless significant misstatements are found in the sample.

Assume that you select a sample of 200 sample items for testing and you find one mis-

statement in inventory. The recorded value is $987.12 and the audit value is $887.12. Calculate the misstatement bounds for the three combined accounts and reach appropriate audit conclusions.

17-33 (Objectives 17-2, 17-3, 17-4, 17-5) An audit partner is developing an office training program to familiarize her professional staff with audit sampling decision models applicable to the audit of dollar-value balances. She wishes to demonstrate the relationship of sample sizes to population size and estimated population exception rate and the auditor’s specifica- tions as to tolerable misstatement and ARIA. The partner prepared the following table to show comparative population characteristics and audit specifications of the two populations:

Case 1 Case 2 Case 3 Case 4 Case 5

Characteristics of Population 1 Relative to Population 2

Estimated Population Size Exception Rate

Equal Equal Smaller Smaller Larger Equal Equal Larger Larger Equal

Audit Specifications as to a Sample from Population 1 Relative to a Sample from Population 2

Tolerable

Misstatement ARIA

Equal Lower Equal Higher Equal Lower Larger Equal Smaller Higher

Required

In items (1) through (5) you are to indicate for the specific case from the table the required sample size to be selected from population 1 relative to the sample from population 2.

(1) In case 1, the required sample size from population 1 is _____. (2) In case 2, the required sample size from population 1 is _____. (3) In case 3, the required sample size from population 1 is _____. (4) In case 4, the required sample size from population 1 is _____. (5) In case 5, the required sample size from population 1 is _____.

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

Your answer choice should be selected from the following responses: a. Larger than the required sample size from population 2.

b. Equal to the required sample size from population 2.

c. Smaller than the required sample size from population 2.

d. Indeterminate relative to the required sample size from population 2.*

17-34 (Objective 17-5) In auditing the valuation of inventory, the auditor, Claire Butler, decided to use difference estimation. She decided to select an unrestricted random sample of 80 inventory items from a population of 1,840 that had a book value of $175,820. Butler decided in advance that she was willing to accept a maximum misstatement in the popu- lation of $6,000 at an ARIA of 5 percent. There were eight misstatements in the sample, which were as follows:

Total $1,594.79

$1,768.48

$173.69

Audit Value

$ 812.50

12.50

10.00

25.40

600.10

.12

51.06

Book Value

$ 740.50

78.20

51.10

61.50

651.90

0

81.06

Sample Misstatements

$(72.00) 65.70 41.10 36.10 51.80

(.12)

30.00

83.11

104.22

21.11

________

________

_______

a. Calculate the point estimate, the computed precision interval, the confidence interval, and the confidence limits for the population. Label each calculation. Use a computer for this purpose (instructor’s option).

b. Should Butler accept the book value of the population? Explain.

c. What options are available to her at this point?

17-35 (Objective 17-5) Marjorie Jorgenson, CPA, is verifying the accuracy of outstanding

accounts payable for Marygold Hardware, a large, single-location retail hardware store. There are 650 vendors listed on the outstanding accounts payable list. She has eliminated from the population 40 vendors that have large ending balances and will audit them separately. There are now 610 vendors.

She plans to do one of three tests for each item in the sample: examine a vendor’s state- ment in the client’s hands, obtain a confirmation when no statement is on hand, or exten- sively search for invoices when neither of the first two is obtained. There is no accounts payable master file available, and a large number of misstatements are expected. Marjorie has obtained facts or made audit judgments as follows:

Required

ARIR

Tolerable misstatement Recorded book value

20% ARIA 10%

$ 45,000 Expected misstatement

$ 600,000 Estimated standard deviation

$ 20,000 $ 280

a. Under what circumstances is it desirable to use difference estimation in the situation described? Under what circumstances is it undesirable?

b. Calculate the required sample size for the audit tests of accounts payable using difference estimation, assuming that ARIR is ignored.

c. Assume that the auditor selects exactly the sample size calculated in part b. The point estimate calculated from the sample results is $21,000 and the estimated population standard deviation is 267. Is the population fairly stated as defined by the decision rule? Explain what causes the result to be acceptable or unacceptable.

d. Calculate the required sample size for the audit tests of accounts payable, assuming that the ARIR is considered.

e. Explain the reason for the large increase of the sample size resulting from including ARIR in determining sample size.

Required

*AICPA adapted.

Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 597

598

CASES

Required

a. Plan the sample size for the confirmation of accounts receivable using MUS.

b. Plan the sample size for the test of pricing of inventories using MUS.

c. Plan the combined sample size for both the confirmation of accounts receivable and the price tests of inventory using MUS.

d. (Instructor’s option) Using an electronic spreadsheet, generate a list of random dollars in generation order and in ascending order for the sample of accounts receivable items determined in part a.

17-37 (Objectives 17-2, 17-3) You have just completed the accounts receivable confir- mation process in the audit of Danforth Paper Company, a paper supplier to retail shops and commercial users. Following are the data related to this process:

17-36 (Objective 17-3) You are doing the audit of Peckinpah Tire and Parts, a wholesale auto parts company. You have decided to use monetary unit sampling (MUS) for the audit of accounts receivable and inventory. The following are the recorded balances:

Accounts receivable $12,000,000 Inventory $23,000,000

You have already made the following judgments:

Materiality for planning purposes $800,000 Acceptable audit risk 5% Inherent risk:

Accounts receivable 80%

Inventory 100% Assessed control risk:

Accounts receivable 50% Inventory 80%

Analytical procedures have been planned for inventory, but not for accounts receivable. The analytical procedures for inventory are expected to have a 60% chance of detecting a material misstatement should one exist.

You have concluded that it will be difficult to alter sample size for accounts receivable confirmation once confirmations are sent and replies are received. However, inventory tests can be reopened without great difficulty.

After discussions with the client, you believe that the accounts are in about the same condition this year as they were last year. Last year no misstatements were found in the confir- mation of accounts receivable. Inventory tests revealed an overstatement amount of about 1%.

For requirements a–c, make any assumptions necessary in deciding the factors affecting

sample size. If no table is available for the ARIA chosen, estimate sample size judgmentally.

Accounts receivable recorded balance Number of accounts

A nonstatistical sample was taken as follows:

All accounts over $10,000 (23 accounts)

77 accounts under $10,000

Tolerable misstatement for the confirmation test Inherent and control risk are both high

No relevant analytical procedures were performed

The following are the results of the confirmation procedures:

$ 2,760,000 7,320

$ 465,000 $ 81,500 $ 100,000

Items over $10,000 $ 465,000 Items under $10,000 81,500

$ 432,000 77,150

Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE

Recorded Value Audited Value

(continued on following page)

 

Individual misstatements for items under $10,000: Item 12

Item 19 Item 33 Item 35 Item 51 Item 59 Item 74

5,120 485 1,250 3,975 1,850 4,200 2,405

4,820 385 250 3,875 1,825 3,780 0

Recorded Value

Audited Value

a. Evaluate the results of the nonstatistical sample. Consider both the direct implications Required of the misstatements found and the effect of using a sample.

b. Assume that the sample was a PPS sample. Evaluate the results using monetary unit sampling.

c. (Instructor’s option) Do the preceding analyses using an electronic spreadsheet.

ACL PROBLEM

17-38 (Objective 17-3) This problem requires the use of ACL software, which is included in the CD attached to the text. Information about installing and using ACL and solving this problem can be found in Appendix, pages 838–842. You should read all of the reference material, especially the material on sampling, to answer questions a–e. For this problem use the “Inventory” file in the “Inventory_Review” subfolder under tables in Sample_Project. Suggested commands, where applicable, are indicate at the end of the problem requirements.

a. Calculate the sample size and sampling interval for an MUS sample based on inven- Required tory value at cost (Value). Use a confidence level of 90%, materiality of $40,000, and

expected errors of $2,500. (Sampling/Calculate Sample Size; select “monetary” radio

button)

 

b. What is the sampling size and sampling interval if you increase materiality to $50,000 and decrease expected errors to $1,000?

c. Select the sample based on the sampling interval determined in part a. (Sampling /Sample Records; select “Sample type” as MUS. For “Sample Parameters” select fixed interval and enter the interval from part a.; use a random start of 3179.)

d. How many items were selected for testing? Why is this number less than the sample size determined in part a?

e. What is the largest item selected for testing? How many sample items are larger than the sampling interval? How many items are larger than the sampling interval in the population?

INTERNET PROBLEM 17-1: MONETARY UNIT SAMPLING CONSIDERATIONS

Monetary unit sampling (MUS) is the most commonly used statistical method of sampling for tests of details because of its simplicity and its ability to provide statistical results in dollars. Read an article titled “Monetary-Unit Sampling Using Microsoft Excel” that appeared in the May 2005 issue of The CPA Journal (www.nysscpa.org/cpajournal/2005/ 505/essentials/p36.htm) to answer the following questions.

a. The authors suggest that there are three critical steps in applying MUS. What are these Required steps?

b. How do the authors indicate that an MUS sample size is determined?

c. What two factors must be considered when evaluating the results of the sample?

Chapter 18

REVIEW QUESTIONS

that specifies the details of an acquisition   tranPsacDtioFn anEd anmhouantnofcmeonrey owed

18-1 (Objective 18-1) List five asset accounts, three liability accounts, and five expense accounts included in the acquisition and payment cycle for a typical manufacturing company.

18-2 (Objective 18-3) List one possible internal control for each of the six transaction- related audit objectives for cash disbursements. For each control, list a test of control to test its effectiveness.

18-3 (Objective 18-3) List one possible control for each of the six transaction-related audit objectives for acquisitions. For each control, list a test of control to test its effectiveness.

18-4 (Objective 18-3) Evaluate the following statement by an auditor concerning tests of acquisitions and cash disbursements: “In selecting the acquisitions and cash disbursements sample for testing, the best approach is to select a random month and test every transaction

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 621

622

for the period. Using this approach enables me to thoroughly understand internal control because I have examined everything that happened during the period. As a part of the monthly test, I also test the beginning and ending bank reconciliations and prepare a proof of cash for the month. At the completion of these tests I feel I can evaluate the effectiveness of internal control.”

18-5 (Objective 18-3) What is the importance of cash discounts to the client and how can the auditor verify whether they are being taken in accordance with company policy?

18-6 (Objective 18-3) What are the similarities and differences in the objectives of the following two procedures? (1) Select a random sample of receiving reports and trace them to related vendors’ invoices and acquisitions journal entries, comparing the vendor’s name, type of material and quantity acquired, and total amount of the acquisition. (2) Select a random sample of acquisitions journal entries and trace them to related vendors’ invoices and receiving reports, comparing the vendor’s name, type of material and quantity acquired, and total amount of the acquisition.

18-7 (Objectives 18-2, 18-3) If an audit client does not have prenumbered checks, what type of misstatement has a greater chance of occurring? Under the circumstances, what audit procedure can the auditor use to compensate for the deficiency?

18-8 (Objective 18-2) What is meant by a voucher? Explain how its use can improve an organization’s internal controls.

18-9 (Objective 18-2) Explain why most auditors consider the receipt of goods and services the most important point in the acquisition and payment cycle.

18-10 (Objectives 18-3, 18-6) Explain the relationship between tests of the acquisition and payment cycle and tests of inventory. Give specific examples of how these two types of tests affect each other.

18-11 (Objectives 18-3, 18-4) Explain the relationship between tests of the acquisition and

payment cycle and tests of accounts payable. Give specific examples of how these two types

of tests affect each other.

18-12 (Objective 18-6) The CPA examines all unrecorded invoices on hand as of February 28, 2012, the last day of the audit. Which of the following misstatements is most likely to be uncovered by this procedure? Explain.

a. Accounts payable are overstated at December 31, 2011.

b. Accounts payable are understated at December 31, 2011.

c. Operating expenses are overstated for the 12 months ended December 31, 2011. d. Operating expenses are overstated for the two months ended February 28, 2012.*

18-13 (Objective 18-7) Explain why it is common for auditors to send confirmation requests to vendors with “zero balances” on the client’s accounts payable listing but uncommon to follow the same approach in verifying accounts receivable.

18-14 (Objectives 18-2, 18-7) Distinguish between a vendor’s invoice and a vendor’s state- ment. Which document should ideally be used as evidence in auditing acquisition transactions and which for verifying accounts payable balances? Why?

18-15 (Objective 18-7) It is less common to confirm accounts payable at an interim date than accounts receivable. Explain why.

18-16 (Objective 18-6) In testing the cutoff of accounts payable at the balance sheet date, explain why it is important that auditors coordinate their tests with the physical obser- vation of inventory. What can the auditor do during the physical inventory to enhance the likelihood of an accurate cutoff?

18-17 (Objective 18-6) Distinguish between FOB destination and FOB origin. What procedures should the auditor follow concerning acquisitions of inventory on an FOB origin basis near year-end?

*AICPA adapted.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

18-18 (Objective 18-3) The following questions concern internal controls in the acquisi- tion and payment cycle. Choose the best response.

a. A client erroneously recorded a large purchase twice. Which of the following internal controls would be most likely to detect this error in a timely and efficient manner? (1) Footing the purchases journal.

(2) Reconcilingvendors’monthlystatementswithsubsidiarypayableledgeraccounts. (3) Tracing totals from the purchases journal to the ledger accounts.

(4) Sending written quarterly confirmations to all vendors.

b. Budd, the purchasing agent of Lake Hardware Wholesalers, has a relative who owns a retail hardware store. Budd arranged for hardware to be delivered by manufacturers to the relative’s retail store on a COD basis, thereby enabling his relative to buy at Lake’s wholesale prices. Budd was probably able to accomplish this because of Lake’s poor internal control over

(1) purchase requisitions. (3) cash receipts.

(2) purchase orders. (4) perpetual inventory records.

c. Which of the following is an internal control that will prevent paid cash disbursement documents from being presented for payment a second time?

(1) The date on cash disbursement documents must be within a few days of the date

that the document is presented for payment.

(2) Theofficialsigningthecheckcomparesthecheckwiththedocumentsandshould

deface the documents.

(3) Unsignedchecksarepreparedbyindividualswhoareresponsibleforsigningchecks.

(4) Cash disbursement documents are approved by at least two responsible manage-

ment officials.

d. Which of the following questions would be best to include in an internal control

questionnaire concerning the completeness assertion for purchases?

(1) Is an authorized purchase order required before the receiving department can

accept a shipment or the vouchers payable department can record a voucher?

(2) Are purchase requisitions prenumbered and independently matched with vendor

invoices?

(3) Is the unpaid voucher file periodically reconciled with inventory records by an

employee who does not have access to purchase requisitions?

(4) Are purchase orders, receiving reports, and vouchers prenumbered and periodi-

cally accounted for?

18-19 (Objectives 18-6, 18-7) The following questions concern accumulating evidence in the acquisition and payment cycle. Choose the best response.

a. In auditing accounts payable, an auditor’s procedures most likely will focus primarily on management’s assertion of

(1) existence. (3) completeness.

(2) realizable value. (4) valuation and allocation.

b. Which of the following audit procedures is best for identifying unrecorded trade accounts payable?

(1) Examining unusual relationships between monthly accounts payable balances

and recorded cash payments.

(2) Reconciling vendors’ statements to the file of receiving reports to identify items

received just prior to the balance sheet date.

(3) Reviewing cash disbursements recorded subsequent to the balance sheet date to

determine whether the related payables apply to the prior period.

(4) Investigating payables recorded just prior to and just subsequent to the balance

sheet date to determine whether they are supported by receiving reports.

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 623

624

c. An auditor traced a sample of purchase orders and the related receiving reports to the acquisitions journal and cash disbursements journal. The purpose of this substantive test of transactions most likely was to

(1) identify unusually large purchases that should be investigated further.

(2) verify that cash disbursements were for goods actually received. (3) determine that purchases were properly recorded.

(4) test whether payments were for goods actually ordered.

18-20 (Objective 18-3, 18-6) The following questions concern the audit of accounts payable.

a. For effective internal control, the accounts payable department generally should

(1) stamp,perforate,orotherwisecancelsupportingdocumentationafterpaymentis

mailed.

(2) ascertain that each requisition is approved as to price, quantity, and quality by an

authorized employee.

(3) omit information about the quantity ordered on the copy of the purchase order

forwarded to the receiving department prior to receipt of goods.

(4) establish the agreement of the vendor’s invoice with the receiving report and

purchase order.

b. When using confirmations to provide evidence about the completeness assertion for accounts payable, the appropriate population most likely is

(1) vendors with whom the entity has previously done business.

(2) amounts recorded in the accounts payable subsidiary ledger.

(3) payees of checks drawn in the month after year-end. (4) invoices filed in the entity’s open invoice file.

DISCUSSION QUESTIONS AND PROBLEMS

Required

18-21 (Objective 18-3) Questions 1 through 8 are typically found in questionnaires used by auditors to obtain an understanding of internal control in the acquisition and payment cycle. In using the questionnaire for a client, a “yes” response to a question indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Is the purchasing function performed by personnel who are independent of the receiving and shipping functions and the payables and disbursing functions?

2. Are all vendors’ invoices routed directly to accounting from the mailroom?

3. Are all receiving reports prenumbered and the numerical sequence checked by a

person independent of check preparation?

4. Are all extensions, footings, discounts, and freight terms on vendors’ invoices checked

for accuracy?

5. Does a responsible employee review and approve the invoice account distribution

before the transaction is entered in the computer?

6. Are checks automatically posted in the cash disbursements journal as they are prepared?

7. Are all supporting documents properly cancelled at the time the checks are signed?

8. Is the custody of checks after signature and before mailing handled by an employee

independent of all payable, disbursing, cash, and general ledger functions?

a. For each of the preceding questions, state the transaction-related audit objective(s) being fulfilled if the control is in effect.

b. For each internal control, list a test of control to test its effectiveness.

c. For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect.

d. For each of the potential misstatements in part c, list a substantive audit procedure that can be used to determine whether a material misstatement exists.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

18-22 (Objective 18-3) Following are some of the tests of controls and substantive tests of transactions procedures commonly performed in the acquisition and payment cycle. Each is to be done on a sample basis.

1. Trace transactions recorded in the acquisitions journal to supporting documenta- tion, comparing the vendor’s name, total dollar amounts, and authorization for acquisition.

2. Account for a sequence of receiving reports and trace selected ones to related vendors’ invoices and acquisitions journal entries.

3. Review supporting documents for clerical accuracy, correctness of account distribution, and reasonableness of expenditure in relation to the nature of the client’s operations.

4. Examine documents in support of acquisition transactions to make sure that each transaction has an approved vendor’s invoice, receiving report, and purchase order

included.

5. Foot the cash disbursements journal, trace postings of the total to the general ledger,

and trace postings of individual cash disbursements to the accounts payable master

file.

6. Account for a numerical sequence of checks in the cash disbursements journal and

examine all voided or spoiled checks for proper cancellation.

7. Prepare a proof of cash disbursements for an interim month.

8. Compare dates on cancelled checks with dates on the cash disbursements journal

and the bank cancellation date.

a. State whether each procedure above is primarily a test of control or substantive test of transactions.

b. State the purpose(s) of each procedure.

18-23 (Objective 18-3) Donnen Designs, Inc. is a small manufacturer of women’s casual-

wear jewelry, including bracelets, necklaces, earrings, and other moderately priced accessory

items. Most of their products are made from silver, various low-cost stones, beads, and other

Required

decorative jewelry pieces. Donnen Designs is not involved in the manufacturing of high-end

jewelry items, such as those made of gold and semiprecious or precious stones.

Personnel responsible for purchasing raw material jewelry items for Donnen Designs would like to place orders directly with suppliers who offer their products for sale through Internet Web sites. Most suppliers provide pictures of all jewelry components on their Web sites, along with pricing and other sales-term information. Customers who have valid business licenses are able to purchase the products at wholesale, rather than retail prices. Customers can place orders online and pay for those goods immediately by using a valid credit card. Purchases made by credit card are shipped by the suppliers after the credit approval is received from the credit card agency, which usually occurs the same day. Customers can also place orders online with payment being later made by check. However, in that event, purchases are not shipped until the check is received and cashed by the supplier. Some of the suppliers allow a 30-day full-payment refund policy, whereas other

suppliers accept returns but only grant credit toward future purchases from that supplier.

a. Identify advantages for Donnen Designs if management allows purchasing personnel to order goods online through supplier Web sites.

b. Identify potential risks associated with Donnen Designs’ purchase of jewelry pieces through supplier Internet Web sites.

c. Describe advantages of allowing purchasing agents to purchase products online using a Donnen Designs credit card.

d. Describe advantages of allowing purchasing agents to purchase products online with payment made only by check.

e. What internal controls can be implemented to ensure that

(1) purchasing agents do not use Donnen credit cards to purchase nonjewelry items

for their own purposes, if Donnen allows purchasing agents to purchase jewelry using Donnen credit cards?

Required

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 625

626

Required

6. Acquisitions of raw materials are often not recorded until several weeks after the goods are received because receiving personnel fail to forward receiving reports to accounting. When pressure from a vendor’s credit department is put on Westgate’s accounting department, it searches for the receiving report, records the transactions in the acquisitions journal, and pays the bill.

a. For each misstatement, identify the transaction-related audit objective that was not met.

b. For each misstatement, state a control that should have prevented it from occurring on a continuing basis.

c. For each misstatement, state a substantive audit procedure that could uncover it.

18-25 (Objectives 18-5, 18-6, 18-7) The following auditing procedures were performed in the audit of accounts payable:

1. Obtain a list of accounts payable. Re-add and compare with the general ledger.

2. Trace from the general ledger trial balance and supporting documentation to deter- mine whether accounts payable, related parties, and other related assets and

liabilities are properly included on the financial statements.

3. For liabilities that are payable in a foreign currency, determine the exchange rate and

check calculations.

4. Discuss with the bookkeeper whether any amounts included on the accounts

payable list are due to related parties, debit balances, or notes payable.

5. Obtain vendors’ statements from the controller and reconcile them to the listing of

accounts payable.

6. Obtain vendors’ statements directly from vendors and reconcile them to the listing

of accounts payable.

7. Examine supporting documents for cash disbursements several days before and after

year-end.

(2) purchasing agents do not order jewelry items from the suppliers and ship those items to addresses other than Donnen addresses?

(3) Donnen does not end up with unused credits with jewelry suppliers as a result of returning unacceptable jewelry items to suppliers who only grant credit toward future purchases?

18-24 (Objectives 18-3, 18-6) The following misstatements are included in the accounting records of Westgate Manufacturing Company.

1. The accounts payable clerk prepares a monthly check to Story Supply Company for the amount of an invoice owed and submits the unsigned check to the treasurer for payment along with related supporting documents that have already been approved. When she receives the signed check from the treasurer, she records it as a debit to accounts payable and deposits the check in a personal bank account for a company named Story Company. A few days later, she records the invoice in the acquisitions journal again, resubmits the documents and a new check to the treasurer, and sends the check to the vendor after it has been signed.

2. The amount of a check in the cash disbursements journal is recorded as $4,612.87 instead of $6,412.87.

3. The accounts payable clerk intentionally excluded from the cash disbursements journal seven large checks written and mailed on December 26 to prevent cash in the bank from having a negative balance on the general ledger. They were recorded on January 2 of the subsequent year.

4. Each month, a fraudulent receiving report is submitted to accounting by an employee in the receiving department. A few days later, he sends Westgate an invoice for the quantity of goods ordered from a small company he owns and operates in the evening. A check is prepared, and the amount is paid when the receiving report and the vendor’s invoice are matched by the accounts payable clerk.

5. Telephone expense (account 2112) was unintentionally charged to repairs and maintenance (account 2121).

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

8. Examine the acquisitions and cash disbursements journals for the last few days of the current period and first few days of the succeeding period, looking for large or unusual transactions.

a. For each procedure, identify the type of audit evidence used.

b. For each procedure, identify which balance-related audit objective(s) were satisfied. c. Evaluate the need to have certain objectives satisfied by more than one audit procedure.

18-26 (Objectives 18-3, 18-4) In testing cash disbursements for the Jay Klein Company, you obtained an understanding of internal control. The controls are reasonably good, and no unusual audit problems arose in previous years.

Although there are not many individuals in the accounting department, there is a reasonable separation of duties in the organization. There is a separate purchasing agent who is responsible for ordering goods and a separate receiving department that counts the goods when they are received and prepares receiving reports. There is a separation of duties between recording acquisitions and cash disbursements, and all information is recorded in the two journals independently. The controller reviews all supporting documents before signing the checks, and he immediately mails the checks to the vendors. Check copies are used for subsequent recording.

All aspects of internal control seem satisfactory to you, and you perform minimum tests of 25 transactions as a means of assessing control risk. In your tests, you discover the following exceptions:

1. Two items in the acquisitions journal were misclassified.

2. Three invoices were not initialed by the controller, but there were no dollar misstate-

ments evident in the transactions.

3. Five receiving reports were recorded in the acquisitions journal at least 2 weeks later

than their date on the receiving report.

4. One invoice was paid twice. The second payment was supported by a duplicate copy

Required

a.

b. c. d.

e. f .

packets. One vendor’s invoice had an extension error, and the invoice was initialed that the amount had been checked.

Identify whether each of 1 through 7 is a control test deviation, a monetary mis- statement, or both.

For each exception, identify which transaction-related audit objective was not met. What is the audit importance of each of these exceptions?

What follow-up procedures would you use to determine more about the nature of each exception?

How would each of these exceptions affect the rest of your audit? Be specific. Identify internal controls that should have prevented each misstatement.

Required

of the invoice. Both copies of the invoice were marked “paid.”

5. One check amount in the cash disbursements journal was for $100 less than the amount stated on the vendor’s invoice.

6. One voided check was missing.

7. Two receiving reports for vendors’ invoices were missing from the transaction

18-27 (Objective 18-3, 18-6) The Broughton Cap Company requires that prenumbered receiving reports be completed when purchased inventory items arrive in the receiving department. At the time of receipt, the receiving clerk writes the date of receipt on the receiving document. The last receipt in the fiscal year ended June 30, 2011 was recorded on receiving report 7279. The accounts payable department prepares prenumbered voucher packages as receiving reports are received from the receiving department. Entries in the acquisitions journal are prepared using information contained in the voucher package.

For late June 2011 and early July 2011, receipts of goods are included in voucher packages as follows:

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 627

628

Receiving Report No.

Voucher No.

7276 7277 7278 7279 7280 7281 7282

2532 2526 2527 2530 2531 2528 2529

The June 2011 and July 2011 acquisitions journals included the following information:

Day of Month

29 29 30 30

Day of Month

1 1 2

Voucher No.

2526 2528 2531 2532

Amount of Purchase

$ 7,256.22 $3,466.10 $8,221.89 $1,980.44

ACQUISITIONS JOURNAL – JUNE 2011

Required

related to purchases.

18-28 (Objective 18-6) You were in the final stages of your audit of the financial statements of Ozine Corporation for the year ended December 31, 2011, when you were consulted by the corporation’s president, who believes there is no point to your examining the year 2012 acquisitions journal and testing data in support of year 2012 entries. He stated that (a) bills pertaining to 2011 that were received too late to be included in the December acquisitions journal were recorded as of the year-end by the corporation by journal entry, (b) the internal auditor made tests after the year-end, and (c) he will furnish you with a letter certifying that there were no unrecorded liabilities.

a. Should a CPA’s test for unrecorded liabilities be affected by the fact that the client made a journal entry to record 2011 bills that were received late? Explain.

b. Should a CPA’s test for unrecorded liabilities be affected by the fact that a letter is obtained in which a responsible management official certifies that to the best of his or her knowledge all liabilities have been recorded? Explain.

c. Should a CPA’s test for unrecorded liabilities be eliminated or reduced because of the internal audit tests? Explain.

d. Assume that the corporation, which handled some government contracts, had no internal auditor but that an auditor for a federal agency spent 3 weeks auditing the records and was just completing his work at this time. How will the CPA’s unrecorded liability test be affected by the work of the auditor for a federal agency?

e. What sources in addition to the year 2012 acquisitions journal should the CPA con- sider to locate possible unrecorded liabilities?*

*AICPA adapted.

ACQUISITIONS JOURNAL – JULY 2011

Voucher No.

2527 2529 2530

Amount of Purchase

$5,001.99 $4,888.33 $1,933.74

Required

a. Which voucher packages, if any, are recorded in the wrong accounting period? Prepare an adjusting entry to correct the financial statements for the year ended June 30, 2011. Assume Broughton uses a perpetual inventory system and all purchases are inventory items.

b. Assume the receiving clerk accidentally wrote June 30 on receiving reports 7280 through 7282. Explain how that will affect the correctness of the financial statements. How will you, as an auditor, discover that error?

c. Describe, in general terms, the audit procedures you would follow in making sure that

cutoff for purchases is accurate at the balance sheet date.

d. Identify internal controls that will reduce the likelihood of cutoff misstatements

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

18-29 (Objective 18-3) Even though Bergeron Wholesale Company is privately held, management has decided that it is worthwhile to have effective internal controls to the extent it is practical in a small company, as a way to reduce the likelihood of error and fraud. They have implemented the following system for acquisitions and payments.

Prenumbered purchase orders are approved and initialed by the vice president of finance for all purchases, including both tangible and service acquisitions. When good are received the goods are counted and a prenumbered receiving report is prepared with a copy sent to accounting. The goods are stored in the warehouse under the control of the shipping manager. The receiving report is used to update the perpetual records, which include only quantities and are used to determine the need to reorder goods and for control over the physical quantities of inventory. When a vendor’s invoice is received, the chief accountant compares it to the purchase order, and for tangible goods the receiving report, for both accuracy and appropriateness of the expenditure, then staples the documents and initials each vendor’s invoice. She then records the transaction in the purchases journal and related records using small business accounting software. Password protection is used for all records to prevent unauthorized access. The chief accountant prepares the checks and updates the cash disburse- ments journal using the same accounting software and submits the checks to Bergeron’s president for signature along with all supporting documentation. The president reviews and initials all support before signing checks and mails them to vendors on his way home from work. The controller receives the monthly bank reconciliation directly from the bank and does a detailed reconciliation, including examining cancelled checks and supporting documentation for larger and unusual amounts. The controller also receives the monthly accounts payable listing from the chief accountant, compares the total to the general ledger, initials the listing and files it. Once each quarter the inventory is counted and compared to the perpetual records, both as a check on record keeping and to determine if there are inventory losses. Differences are listed, used for discussion with the controller and shipping manager, and filed.

a. List at least ten internal controls in the Bergeron acquisition and payment cycle. Be as specific as possible.

b. For each control, identify the tAranpsactgiono-relaPteDd aFuditEobnjehctiave(ns)ctoewrhich the control relates.

c. For each control, list one test of control that is useful to test the effectiveness of the control. Be as specific as possible.

18-30 (Objective 18-7) As part of the June 30, 2011, audit of accounts payable of Milner Products Company, the auditor sent 22 confirmations of accounts payable to vendors in the form of requests for statements. Four of the statements were not returned by the vendors, and five vendors reported balances different from the amounts recorded in Milner’s accounts payable master file. The auditor made duplicate copies of the five vendors’ statements to maintain control of the independent information and turned the originals over to the client’s accounts payable clerk to reconcile the differences. Two days later, the clerk returned the five statements to the auditor with the information on the audit schedule following part c.

a. Evaluate the acceptability of having the client perform the reconciliations, assuming that the auditor intends to perform adequate additional tests.

b. Describe the additional tests that should be performed for each of the five statements that included differences.

c. What audit procedures should be performed for the nonresponses to the confirma- tion requests?

Required

Required

Statement 1

Statement 2

Balance per vendor’s statement Payment by Milner on June 30, 2011

Balance per master file

Balance per vendor’s statement Invoices not received by Milner Payment by Milner on June 15, 2011

$ 6,618.01

(4,601.01) _________

$ 2,017.00

$ 9,618.93

(2,733.18)

(1,000.00) _________

Balance per master file

$ 5,885.75

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 629

630

Statement 3

Statement 4

Statement 5

Balance per vendor’s statement Balance per master file

Difference cannot be located because the vendor failed to provide details of its account balance

Balance per vendor’s statement

Credit memo issued by vendor on July 15, 2011

Balance per master file

Balance per vendor’s statement Payment by Milner on July 3, 2011 Unlocated difference not followed up

because of minor amount

Balance per master file

$26,251.80

(20,516.11) _________

$ 5,735.69

$ 6,170.15

(2,360.15) _________

$ 3,810.00

$ 8,619.21 (3,000.00)

215.06 _________

$ 5,834.27

18-31 (Objective 18-6) The physical inventory for Ajak Manufacturing was taken on December 30, 2011, rather than December 31, because the client had to operate the plant for a special order the last day of the year. At the time of the client’s physical count, you observed that acquisitions represented by receiving report number 2631 and all preceding ones were included in the physical count, whereas inventory represented by succeeding numbers was excluded. On the evening of December 31, you stopped by the plant and noted that inventory represented by receiving report numbers 2632 through 2634 was received subsequent to the physical count but before the end of the year. You later noted that the final inventory on the financial statements contained only those items included in the physical count. In testing accounts payable at December 31, 2011, you obtain a schedule from the client to aid you in testing the adequacy of the cutoff. The following schedule includes the information that you have not yet resolved:

Amount Presently

Receiving Amount of Included in or

INFORMATION ON THE VENDOR’S INVOICE

 

FOB Origin or Destination

Origin Destination Origin Destination Origin Destination Origin Origin

Report Vendor’s Excluded from

Number

Invoice

Accounts Payable*

Invoice Date

Shipping Date

12-30-11 12-15-11 12-26-11 12-27-11 12-31-11 12-31-11 12-26-11 01-03-12

2631 2632 2633 2634 2635 2636 2637 2638

$4,256.40 6,320.54 3,761.22 7,832.18 6,847.77 6,373.58 5,878.36 3,355.05

Included Excluded Included Excluded Included Excluded Excluded Excluded

12-30-11 12-26-11 12-31-11 12-16-11 12-28-11 01-03-12 01-05-12 12-31-11

Required

CASE

*All entries to record inventory acquisitions are recorded by the client as a debit to purchases and a credit to accounts payable.

a. Explain the relationship between inventory and accounts payable cutoff.

b. For each of the receiving reports, state the misstatement in inventory or accounts payable, if any exists, and prepare an adjusting entry to correct the financial state- ments, if a misstatement exists.

c. Which of the misstatements in part b are most important? Explain.

18-32 (Objectives 18-2, 18-3, 18-4, 18-6) The following tests of controls and substantive tests of transactions audit procedures for acquisitions and cash disbursements are to be used in the audit of Ward Publishing Company. You concluded that internal control appears effective and a reduced assessed control risk is likely to be cost beneficial. Ward’s active involvement in the business, good separation of duties, and a competent controller and other employees are factors affecting your opinion.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

Ward Publishing Company — Part I

(See page 632 for Part II, and Case 19-28 on pages 655–656 for Part III)

Tests of Controls and Substantive Tests of Transactions Audit Procedures for Acquisitions and Cash Disbursements

1. Foot and cross-foot the acquisitions and cash disbursements journals for 2 months and trace totals to postings in the general ledger.

2. Scan the acquisitions and cash disbursements journals for all months and investigate any unusual entries.

3. Reconcile cash disbursements per books to cash disbursements per bank statement for 1 month.

4. Examine evidence that the bank reconciliation is prepared by the controller.

5. Inquire and observe whether the accounts payable master file balances are peri-

odically reconciled to vendors’ statements by the controller.

6. Examine the log book as evidence that the numerical sequence of checks is accounted

for by someone independent of the preparation function.

7. Inquire and observe that checks are mailed by D. Ward or someone under his

supervision after he signs checks.

8. Examine initials indicating that the controller balances the accounts payable master

file to the general ledger monthly.

9. Select a sample of entries in the cash disbursements journal, and

a. obtain related cancelled checks and compare with entry for payee, date, and amount and examine signature endorsement.

b. obtain vendors’ invoices, receiving reports, and purchase orders, and

(1) determinethatsupportingdocumentsareattachedtovendors’invoices.

(2) determinethatdocumentsagreewiththecashdisbursementsjournal.

(3) comparevendors’names,amounts,anddateswithentries.

(4) determinewhetheradiscountwastakenwhenappropriate.

(5) examine vendors’ invoices for initials indicating an independent review of

chart of account codings.

(6) examinereasonablenessofcashdisbursementsandaccountcodings.

(7) reviewinvoicesforapprovalofacquisitionsbyWard.

(8) reviewpurchaseordersand/orpurchaserequisitionsforproperapproval.

(9) verifypricesandrecalculatefootingsandextensionsoninvoices.

(10) compare quantities and descriptions on purchase orders, receiving reports, and vendors’ invoices to the extent applicable.

(11) examinevendors’invoicesandreceivingreportstodeterminethatthecheck numbers are included and the documents are marked “paid” at the time of check signing.

c. Trace postings to the accounts payable master file for name, amount, and date. 10. Select a sample of receiving reports issued during the year and trace to vendors’

invoice and entries in the acquisitions journal.

a . Compare type of merchandise, name of vendor, date received, quantities, and amounts. b. If the transaction is indicated in the acquisitions journal as paid, trace the check

number to the entry in the cash disbursements journal. If unpaid, investigate reasons. c . Trace transactions to accounts payable master file, comparing name, amount, and date.

Prepare all parts of a sampling data sheet (such as the one in Figure 15-2 on page 490) through the planned sample size for the preceding audit program, assuming that a line item in the cash disbursements journal is used for the sampling unit. Use either nonstatistical or attributes sampling. For all procedures for which the line item in the cash disbursements journal is not an appropriate sampling unit, assume that audit procedures were performed on a nonsampling basis. For all tests of controls, use a tolerable exception rate of 5%, and for all substantive tests of transactions, use a rate of 6%. Use an ARACR of 10%, which is considered medium. Plan for an estimated population exception rate of 1% for tests of con- trols and 0% for substantive tests of transactions.

Prepare the data sheet using the computer (instructor option—also applies to Part II).

Required

Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 631

 

632

Required

Part II

Assume a sample size of 50 for all procedures, regardless of your answers in Part I. For other procedures, assume that an adequate sample size for the circumstance was selected. The only exceptions in your audit tests for all tests of controls and substantive tests of transactions audit procedures are as follows:

1. Procedure 2—Two large transactions were identified as being unusual. Investigation determined that they were authorized acquisitions of fixed assets. They were both correctly recorded.

2. Procedure 9b(1)—A purchase order was not attached to a vendor’s invoice. The pur- chase order was found in a separate file and determined to be approved and appropriate. 3. Procedure 9b(5)—Six vendors’ invoices were not initialed as being internally verified. Three actual misclassifications existed. The controller explained that he often did not review codings because of the competence of the accounting clerk

doing the coding and was surprised at the mistakes.

a. Complete the sampling data sheet from Part I using either nonstatistical or attributes sampling.

b. Explain the effect of the exceptions on tests of details of accounts payable. Which balance-related audit objectives are affected, and how do those objectives, in turn, affect the audit of accounts payable?

c. Given your tests of controls and substantive tests of transactions results, write an audit program for tests of details of balances for accounts payable. Assume:

(1) The client provided a list of accounts payable, prepared from the master file.

(2) Acceptable audit risk for accounts payable is high.

(3) Inherent risk for accounts payable is low. (4) Analytical procedure results were excellent.

INTERNET PROBLEM 18-1:

Required

The embezzlement of funds from organizations is often orchestrated through fictitious accounts payable and related cash disbursement transactions. The AuditNet online resource center for auditors includes information about typical accounts payable fraud techniques. Visit http://www.auditnet.org and select the link for “Virtual Library” to search for a two-part series article “Ten Ways to Identify Accounts Payable Fraud.” Read both Part 1 and Part 2 of this article to answer the following questions.

a. What contributes to the risk that entities fail to detect duplicate payments to vendors?

b. What techniques might help detect duplicate payments?

c. How can applying Benford’s law help detect fraudulent accounts payable transactions?

d. What techniques can be used to identify fraudulent transactions that are just below amounts for required approvals?

e. What techniques might help detect fictitious vendors in the vendor master file that might result in unauthorized payments being sent to employees?

Chapter 19

REVIEW QUESTIONS

individual transactions and amounts making up the total of an expense account

Fixed asset master file—a computer file containing records for each piece of equipment and other types of property owned; the primary accounting record for manufacturing equipment and other property, plant, and equipment accounts

Insurance register—a record of insurance policies in force, the expiration date of each policy, premium amount and terms, and other policy specifics

19-1 (Objective 19-2) Explain the relationship between substantive tests of transactions for the acquisition and payment cycle and tests of details of balances for the verification of properAty,plantg, aond eqPuipDmFent. WEhnichasapenctscofeproperty, plant, and equipment are directly affected by the tests of controls and substantive tests of transactions and which are not?

19-2 (Objective 19-2) Explain why the emphasis in auditing property, plant, and equip- ment is on the current period acquisitions and disposals rather than on the balances in the account carried forward from the preceding year. Under what circumstances will the emphasis be on the balances carried forward?

19-3 (Objective 19-2) What is the relationship between the audit of property, plant, and equipment accounts and the audit of repair and maintenance accounts? Explain how the auditor organizes the audit to take this relationship into consideration.

19-4 (Objective 19-2) List and briefly state the purpose of all audit procedures that might reasonably be applied by an auditor to determine that all property, plant, and equipment retirements have been recorded in the accounting system.

19-5 (Objective 19-2) In auditing depreciation expense, what major considerations should the auditor keep in mind? Explain how each can be verified.

19-6 (Objective 19-3) Explain the relationship between substantive tests of transactions for the acquisition and payment cycle and tests of details of balances for the verification of prepaid insurance.

19-7 (Objective 19-3) Explain why the audit of prepaid insurance should ordinarily take a relatively small amount of audit time if the client’s assessed control risk for acquisitions is low.

19-8 (Objective 19-3) Distinguish between the evaluation of the adequacy of insurance coverage and the verification of prepaid insurance. Explain which is more important in a typical audit.

19-9 (Objective 19-3) What are the major differences between the audit of prepaid expenses and other asset accounts such as accounts receivable or property, plant, and equipment?

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

19-10 (Objective 19-4) Explain the relationship between accrued rent and substantive tests of transactions for the acquisition and payment cycle. Which aspects of accrued rent are not verified as part of the substantive tests of transactions?

19-11 (Objective 19-4) In verifying accounts payable, it is common to restrict the audit sample to a small portion of the population items, whereas in auditing accrued property taxes, it is common to verify all transactions for the year. Explain the reason for the difference.

19-12 (Objective 19-4) Which documents will be used to verify accrued property taxes and the related expense accounts?

19-13 (Objective 19-5) List three expense accounts that are tested as part of the acquisition and payment cycle or the payroll and personnel cycle. List three expense accounts that are not directly verified as part of the cycle.

19-14 (Objective 19-5) What is meant by the analysis of expense accounts? Explain how expense account analysis relates to the tests of controls and substantive tests of transactions that the auditor has already completed for the acquisition and payment cycle.

19-15 (Objectives 19-2, 19-5) How will the approach for verifying repair expense differ from that used to audit depreciation expense? Why will the approach be different?

19-16 (Objective 19-5) List the factors that should affect the auditor’s decision whether to analyze an account balance. Considering these factors, list four expense accounts that are commonly analyzed in audits.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

19-17 (Objective 19-2) The following questions concern internal controls in the acquisi- tion and payment cycle. Choose the best response.

a. Which of the following controls will most likely justify a reduced assessed level of control risk for the existence assertion for equipment?

(1) Internalauditorsperiodicallyselectequipmentitemsinthefixedassetsmasterfile and locate the related equipment on company premises.

(2) Department heads are asked to provide information to the accounting depart- ment each quarter about any equipment no longer in use or somewhat damaged.

(3) All contracts of equipment purchases are reviewed by both the controller and attorney to verify that legal title transfers to the client and that none represent

operating leases.

(4) As part of quarterly and annual inventory physical counts, factory equipment is

listed and subsequently reconciled to the fixed asset master file.

b. Which of the following is not an internal control deficiency related to factory equipment?

(1) Checks issued in payment of acquisitions of equipment are not signed by the

controller.

(2) All acquisitions of factory equipment are required to be made by the department

in need of the equipment.

(3) Factory equipment replacements are generally made when estimated useful lives,

as indicated in depreciation schedules, have expired.

(4) Proceeds from sales of fully depreciated equipment are credited to other income.

c. Which of the following controls will most likely justify a reduced assessed level of control risk for the existence assertion related to the equipment account?

(1) As purchases of equipment are recorded in the purchases journal, the system

automatically posts the item to the equipment master file.

(2) Internal auditors physically examines equipment on a periodic basis and verify

that the equipment is included in the equipment master file.

(3) All additions to the equipment account must be supported by a valid receiving

report.

(4) Assignment of general ledger account coding is reviewed by the accounts payable

supervisor as purchases are recorded in the purchases journal.

Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 651

652

19-18 (Objectives 19-2, 19-5) The following questions concern analytical procedures in the acquisition and payment cycle. Choose the best response.

a. Which of the following comparisons will be most useful to an auditor in auditing an entity’s income and expense accounts?

(1) Prior year accounts payable to current year accounts payable.

(2) Prior year payroll expense to budgeted current year payroll expense.

(3) Current year revenue to budgeted current year revenue.

(4) Current year warranty expense to current year contingent liabilities.

b. The controller of Excello Manufacturing, Inc., wants to use analytical procedures to identify the possible existence of idle equipment or the possibility that equipment has been disposed of without having been written off. Which of the following ratios will

best accomplish this objective?

(1) Depreciation expense/book value of manufacturing equipment.

(2) Accumulated depreciation/book value of manufacturing equipment. (3) Repairs and maintenance cost/direct labor costs.

(4) Gross manufacturing equipment cost/units produced.

c. Which of the following analytical procedures might suggest that certain repairs and maintenance expenses have been inappropriately capitalized?

(1) Theratioofadditionstoequipmentdividedbythebeginningbalanceintheequip-

ment account is significantly lower than the same ratio from the prior three years.

(2) The balance in the repairs and maintenance expense account is noticeably lower

than amounts recorded in the past several years.

(3) The balance in the gross equipment account has decreased this year compared to

the prior year.

(4) The ratio of depreciation expense divided by gross equipment is higher in the

current year compared to prior years.

19-19 (Objective 19-2) The following questions concern the audit of asset accounts in the acquisition and payment cycle. Choose the best response.

a. In testing for unrecorded disposals of equipment, an auditor most likely will

(1) select items of equipment from the accounting records and then locate them

during the plant tour.

(2) compare depreciation journal entries with similar prior-year entries in search of

fully depreciated equipment.

(3) inspectitemsofequipmentobservedduringtheplanttourandthentracethemto

the equipment master file.

(4) scan the general journal for unusual equipment additions and excessive debits to

repairs and maintenance expense.

b. Analysis of which account is least likely to reveal evidence related to unrecorded

retirement of equipment?

(1) Accumulateddepreciation. (3) Property,plant,andequipment. (2) Insurance expense. (4) Purchase returns and allowances.

c. In connection with the audit of the prepaid insurance account, which of the following procedures is usually not performed by the auditor?

(1) Recompute the portion of the premium that expired during the year.

(2) Prepare excerpts of the insurance policies for audit documentation.

(3) Confirm premium rates with an independent insurance broker. (4) Examine support for premium payments.

19-20 (Objectives 19-2, 19-4, 19-5) The following questions concern the audit of liabilities or income and expense accounts. Choose the best response.

a. The auditor may note that annual depreciation expense is too low for a class of assets by noting

(1) insured values greatly in excess of carrying amounts. (2) large numbers of fully depreciated assets are still in use. (3) continuous trade-ins of relatively new assets.

(4) excessive recurring losses on assets retired.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

b. Which of the following best describes the independent auditor’s approach to obtain- ing satisfaction concerning depreciation expense in the income statement?

(1) Verifythemathematicalaccuracyoftheamountschargedtoincomeasaresultof

depreciation expense.

(2) Determine the method for computing depreciation expense and ascertain that it

is in accordance with accounting standards.

(3) Reconcile the amount of depreciation expense to those amounts credited to

accumulated depreciation accounts.

(4) Establish the basis for depreciable assets and verify the depreciation expense.

c . Before expressing an opinion concerning the audit of income and expenses, the auditor will best proceed with the audit of the income statement by

(1) applyingarigidmeasurementstandarddesignedtotestforunderstatementofnet

income.

(2) analyzing the beginning and ending balance sheet inventory amounts.

(3) making net income comparisons to published industry trends and ratios.

(4) auditing income statement accounts concurrently with the related balance sheet

accounts.

DISCUSSION QUESTIONS AND PROBLEMS

19-21 (Objective 19-2) For each of the following misstatements in property, plant, and equipment accounts, state an internal control that the client can implement to prevent the misstatement from occurring and a substantive audit procedure that the auditor can use to discover the misstatement:

1. The asset lives used to depreciate equipment are less than reasonable, expected useful lives.

2. Capitalizable assets are routinely expensed as repairs and maintenance, perishable

tools, or supplies expense.

3. Acquisitions of property are recorded at incorrect amounts.

4. A loan against existing equipment is not recorded in the accounting records. The

cash receipts from the loan never reached the company because they were used for the down payment on a piece of equipment now being used as an operating asset. The equipment is also not recorded in the records.

5. Computer equipment that is abandoned or traded for replacement equipment is not removed from the accounting records.

6. Depreciation expense for manufacturing operations is charged to administrative expenses.

7. Tools necessary for the maintenance of equipment are stolen by company employees for their personal use.

19-22 (Objective 19-2) The following types of internal controls are commonly used by organizations for property, plant, and equipment:

1. A fixed asset master file is maintained with a separate record for each fixed asset.

2. Written policies exist and are known by accounting personnel to differentiate between capitalizable additions, freight, installation costs, replacements, and maintenance

expenditures.

3. Depreciation charges for individual assets are calculated for each asset; recorded in a

fixed asset master file that includes cost, depreciation, and accumulated depreciation

for each asset; and verified periodically by an independent clerk.

4. Acquisitions of fixed assets in excess of $20,000 are approved by the board of directors. 5. When practical, equipment is labeled with metal tags and is inventoried on a syste-

matic basis.

a. State the purpose of each of the internal controls just listed. Your answer should be in

the form of the type of misstatement that is likely to be reduced because of the control. b. For each internal control, list one test of control the auditor can use to test for its existence.

Required

Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 653

654

Required

12. When the check signer’s assistant writes “paid” on supporting documents, watch whether she does it after the documents are reviewed and the checks are signed.

a. For each procedure, identify the type of evidence being used.

b. For each procedure, identify whether it is an analytical procedure, a test of control, a substantive test of transactions, or a test of details of balances.

c. For each test of control or substantive test of transactions, identify the transaction- related audit objective(s) being met.

d. For each test of details of balances, identify the balance-related audit objective(s) being met.

19-24 (Objective 19-2) Your client, Edgartown Corporation, prepared the following schedule of land, buildings and equipment for the audit of financial statements for the year ended December 31, 2011:

Required

a. What type of evidence would you examine to support the beginning balances in the accounts?

c. List one substantive procedure for testing whether the control is actually preventing misstatements in property, plant, and equipment.

19-23 (Objectives 19-1, 19-2, 19-3, 19-5) The following audit procedures were planned by Linda King, CPA, in the audit of the acquisition and payment cycle for Cooley Products, Inc.:

1. Review the acquisitions journal for large and unusual transactions.

2. Send letters to several vendors, including a few for which the recorded accounts payable balance is zero, requesting them to inform us of their balance due from

Cooley. Ask the controller to sign the letter.

3. Examine a sample of receiving report numbers and determine whether each one has

an initial indicating that it was recorded as an account payable.

4. Select a sample of equipment listed on fixed asset master files and inspect the asset to

determine that it exists and to determine its condition.

5. Refoot the acquisitions journal for 1 month and trace all totals to the general ledger.

6. Calculate the ratio of equipment repairs and maintenance to total equipment and

compare with previous years.

7. Obtain from the client a written statement that all mortgages payable have been

included in the current period financial statements and have been accurately recorded

and that the collateral for each is included in the footnotes.

8. Select a sample of cancelled checks and trace each one to the cash disbursements

journal, comparing the name, date, and amount.

9. For 20 nontangible acquisitions, select a sample of line items from the acquisitions

journal and trace each to related vendors’ invoices. Examine whether each transaction appears to be a legitimate expenditure for the client and that each was approved and recorded at the correct amount and date in the journal and charged to the correct account per the chart of accounts.

10. Examine invoices and related shipping documents included in the client’s unpaid

invoice file at the audit report date to determine whether they were recorded in the

appropriate accounting period and at the correct amounts.

11. Recalculate the portion of insurance premiums on the client’s prepaid insurance schedule that is applicable to future periods.

Account

Description

Land

Building–Office 27,000,000

Production Equipment Office Equipment

IT Hardware

Total

2,345,000 1,765,881

216,542 ____________

$38,827,423

1/1/11

Beginning Balance

Additions

$250,000

178,223

72,517

— _________

$500,740

Disposals

$ 34,779

55,339

19,098 _________

$109,216

12/31/11

Ending Balance

$ 7,500,000

27,250,000

2,488,444

1,783,059

197,444 ____________

$39,218,947

$ 7,500,000

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

b. What types of evidence would you use to support the additions to each account? How might the sources of evidence differ for additions to the building account and the equipment accounts?

c. What types of evidence would you examine to support equipment disposals?

d. What procedures would you perform related to the ending balances in the accounts?

e. In the audit of property, plant, and equipment accounts, auditors should consider

whether there are any implications to other accounts in the audit.

(1) What other accounts might be impacted by the additions of buildings and equip-

ment?

(2) What other accounts might be impacted by disposals of equipment?

19-25 (Objective 19-4) The following program has been prepared for the audit of accrued real estate taxes of a client that pays taxes on 25 different pieces of property, some of which have been acquired in the current year:

1. Obtain a schedule of accrued taxes from the client and tie the total to the general ledger.

2. Compare the charges for annual tax payments with property tax assessment bills.

3. Recompute accrued/prepaid amounts for all bills on the basis of the portion of the

year expired.

a. State the purpose of each procedure.

b. Evaluate the adequacy of the audit program.

19-26 (Objective 19-4) As part of the audit of different audit areas, auditors should be alert for the possibility of unrecorded liabilities. For each of the following audit areas or accounts, describe a liability that can be uncovered and the audit procedures that can uncover it:

a. Minutes of the board of directors meetings b. Land and buildings

Required

c. Rent expense

d. Interest expense

e. Cash surrender value of life insurance

f . Cash in the bank

g. Officers’ travel and entertainment expenses

19-27 (Objective 19-5) While you are having lunch with a banker friend, you become involved in explaining to him how your firm conducts a typical audit. Much to your surprise, your friend is interested and is able to converse intelligently in discussing your philosophy of emphasizing the importance of internal control, analytical procedures, tests of controls, substantive tests of transactions, and tests of details of balance sheet accounts. At the completion of your discussion, he says, “That all sounds great except for a couple of things. The point of view we take these days at our bank is the importance of a continuous earnings stream. You seem to be emphasizing fraud detection and a fairly stated balance sheet. We would rather see you put more emphasis than you apparently do on the income statement.”

How would you respond to your friend’s comments?

Ward Publishing Company — Part III (See Case 18-32 for Parts I and II)

CASES

19-28 (Objectives 19-1, 19-2, 19-5) Examine the tests of controls and substantive tests of transactions results, including the sampling application in Case 18-32 (pp. 630–632), for Ward Publishing Company. Assume that you have already reached several conclusions.

1. Your tests of details of balances for accounts payable are completed, and you found no exceptions.

Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 655

656

Required

2. Acceptable audit risk for property, plant, and equipment and all expenses is high.

3. Inherent risk for property, plant, and equipment is high because in the current year, the client has acquired a material amount of new and used printing equipment and has traded in older equipment. Some of the new equipment was ineffective and returned;

an allowance was received on others. Inherent risk for expense accounts is low.

4. New computer equipment and some printing equipment are being leased. The client

has never leased equipment before.

5. Analytical procedures for property, plant, and equipment are inconclusive because of

the large increases in acquisition and disposal activity.

6. Analytical procedures show that repairs, maintenance, and small tools expenses have

increased materially, both in absolute terms and as a percentage of sales. Two other

expenses have also materially increased, and one has materially decreased.

7. In examining the sample for tests of controls and substantive tests of transactions, you observe that no sample items included any property, plant, and equipment or

lease transactions.

a. Explain the relationship between the tests of controls and substantive tests of trans-

actions results in Case 18-32 and the audit of property, plant, and equipment and leases. b. How will the tests of controls and substantive tests of transactions results and your conclusions (1 through 7) affect your planned tests of details for property, plant, and equipment and leases? State your conclusions for each balance-related audit objective.

Do not write an audit program.

c. Explain the relationship between the tests of controls and substantive tests of trans-

actions results in Case 18-32 and the audit of expenses.

d. How will the tests of controls and substantive tests of transactions results and your

conclusions (1 through 7) affect your planned tests of details of balances for expenses? Do not write an audit program.

19-29 (Objective 19-2) You are doing the audit of the UTE Corporation, for the year ended

December 31, 2011. The following schedule for the property, plant, and equipment and

related allowance for depreciation accounts has been prepared by the client. You have compared the opening balances with your prior year’s audit documentation.

Description

Assets

Land

Buildings

Machinery and equipment

Allowance for Depreciation

Building

Machinery and equipment

Final 12/31/10

$ 225,000

1,200,000

3,850,000 _________

$ 5,275,000

$ 600,000

1,732,500 _________

$ 2,332,500

Additions

$ 50,000

175,000

404,000 ________

$ 629,000

$ 51,500

392,200 ________

$ 443,700

Retirements

260,000 ________

$ 260,000

Per Books 12/31/11

$ 275,000

1,375,000

3,994,000 _________

$ 5,644,000

$ 651,500

2,124,700 _________

$ 2,776,200

UTE Corporation Analysis of Property, Plant, and Equipment and Related Allowance for Depreciation Accounts

Year Ended December 31, 2011

The following information is found during your audit:

1. All equipment is depreciated on the straight-line basis (no salvage value taken into

consideration) based on the following estimated lives: buildings, 25 years; all other items, 10 years. The corporation’s policy is to take one-half year’s depreciation on all asset acquisitions and disposals during the year.

2. On April 1, the corporation entered into a 10-year lease contract for a die-casting machine with annual rentals of $50,000, payable in advance every April 1. The lease is cancelable by either party (60 days’ written notice is required), and there is no option to renew the lease or buy the equipment at the end of the lease. The estimated useful life of the machine is 10 years with no salvage value. The corporation recorded

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

 

the die-casting machine in the machinery and equipment account at $404,000, the present value at the date of the lease, and $20,200, applicable to the machine, has been included in depreciation expense for the year.

3. The corporation completed the construction of a wing on the plant building on June 30. The useful life of the building was not extended by this addition. The lowest construction bid received was $175,000, the amount recorded in the buildings account. Company personnel were used to construct the addition at a cost of $160,000 (materials, $75,000; labor, $55,000; and overhead, $30,000).

4. On August 18, $50,000 was paid for paving and fencing a portion of land owned by the corporation and used as a parking lot for employees. The expenditure was charged to the land account.

5. The amount shown in the machinery and equipment asset retirement column represents cash received on September 5, upon disposal of a machine acquired in July 2007 for $480,000. The bookkeeper recorded depreciation expense of $35,000 on this machine in 2011.

6. Crux City donated land and building appraised at $100,000 and $400,000, respectively, to the UTE Corporation for a plant. On September 1, the corporation began operating the plant. Because no costs were involved, the bookkeeper made no entry for the foregoing transaction.

a. In addition to inquiry of the client, explain how you would have found each of these six items during the audit.

b. Prepare the adjusting journal entries with supporting computations that you would suggest at December 31, 2011, to adjust the accounts for the preceding transactions. Disregard income tax implications.*

19-30 (Objective 19-5) You are the manager in the audit of Vernal Manufacturing Company

and are turning your attention to the income statement accounts. The in-charge auditor

assessed control risk for all cycles as low, supported by tests of controls. There are no major

Required

inherent risks affecting income and expense accounts. Accordingly, you decide that the

major emphasis in auditing the income statement accounts will be to use analytical pro- cedures. The client prepared a schedule of the key income statement accounts that compares the prior-year totals with the current year totals. The in-charge auditor completed the last column of the audit schedule, which includes explanations of variances obtained from discussions with client personnel. The audit schedule is included on page 658.

a. Examine the schedule prepared by the client and your staff and write a memorandum to the in-charge that includes criticisms and concerns about the audit procedures performed and questions for the in-charge auditor to resolve.

b. Evaluate the explanations for variances provided by client personnel. List any alternative explanation to those given.

c. Indicate which variances are of special significance to the audit and how you believe they should be responded to in terms of additional audit procedures.

Required

INTERNET PROBLEM 19-1: CENTERPULSE LTD. FRAUD

The Securities and Exchange Commission (SEC) found that Centerpulse Ltd., a publicly- traded company based in Switzerland, fraudulently misstated its 2002 third and fourth quarter financial statements filed with the SEC. Visit the SEC’s website (www.sec.gov) and search the link to “Litigation Releases” to locate Litigation Release 20336 issued on October 17, 2007 against selected members of the Centerpulse management team. View the SEC Complaint in this matter to learn more about this fraud.

a. What members of management were allegedly involved in the accounting fraud? Required

b. What were the primary incentives that allegedly pressured management to engage in

the fraud?

c. What was the nature of the expense that management inappropriately delayed?

e. The complaint also notes that management failed to write-off an impaired asset. What
were the circumstances resulting in the impairment?

  1. By what percentage amount did these actions overstate Centerpulse’s 2002 pretax
    income?

Chapter 20

20-1 (Objective 20-1) Identify five general ledger accounts that are likely to be affected by the payroll and personnel cycle in most audits.

20-2 (Objectives 20-1, 20-3) Explain the relationship between the payroll and personnel

cycle and inventory valuation.

20-3 (Objective 20-3) List five tests of controls that can be performed for the payroll and personnel cycle and state the purpose of each control tested.

20-4 (Objective 20-3) Explain why the percentage of total audit time in the cycle devoted to performing tests of controls and substantive tests of transactions is usually far greater for the payroll and personnel cycle than for the sales and collection cycle.

20-5 (Objectives 20-2, 20-3) Evaluate the following comment by an auditor: “My job is to determine whether the payroll records are fairly stated in accordance with accounting standards, not to find out whether they are following proper hiring and termination procedures. When I conduct an audit of payroll, I keep out of the human resources department and stick to the time cards, journals, and payroll checks. I don’t care whom they hire and whom they fire, as long as they properly pay the ones they have.”

20-6 (Objective 20-3) Distinguish between the following payroll audit procedures and state the purpose of each: (1) trace a random sample of prenumbered time cards to the related payments in the payroll register and compare the hours worked with the hours paid, and (2) trace a random sample of payments from the payroll register to the related time cards and compare the hours worked with the hours paid. Which of these two procedures is typically more important in the audit of payroll? Why?

20-7 (Objective 20-5) In auditing payroll withholding and payroll tax expense, explain why emphasis should normally be on evaluating the adequacy of the payroll tax return preparation procedures rather than the payroll tax liability. If the preparation procedures are inadequate, explain the effect this will have on the remainder of the audit.

20-8 (Objective 20-4) List several analytical procedures for the payroll and personnel cycle and explain the type of misstatement that might be indicated when there is a significant dif- ference in the comparison of the current year with previous years’ results for each of the tests.

Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE

673

674

20-9 (Objective 20-3) Explain the circumstances under which an auditor should perform audit tests primarily designed to uncover fraud in the payroll and personnel cycle. List three audit procedures that are primarily for the detection of fraud and state the type of fraud the procedure is meant to uncover.

20-10 (Objective 20-2) Distinguish among a payroll master file, a W-2 form, and a payroll tax return. Explain the purpose of each.

20-11 (Objectives 20-2, 20-3) List the supporting documents and records the auditor will examine in a typical payroll audit in which the primary objective is to detect fraud.

20-12 (Objective 20-3) List five types of authorizations in the payroll and personnel cycle and state the type of misstatement that is likely to occur when each authorization is lacking.

20-13 (Objective 20-5) Explain why it is common to verify total officers’ compensation even when the tests of controls and substantive tests of transactions results in payroll are excellent. What audit procedures can be used to verify officers’ compensation?

20-14 (Objective 20-2) Explain what is meant by an imprest payroll account. What is its purpose as a control over payroll?

20-15 (Objective 20-3) List several audit procedures that the auditor can use to determine whether payroll transactions are recorded at the proper amounts.

20-16 (Objective 20-3) Explain how audit sampling can be used to test the payroll and personnel cycle.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

20-17 (Objective 20-3) The following questions concern internal controls in the payroll and personnel cycle. Choose the best response.

a. A factory foreman at Steblecki Corporation discharged an hourly worker but did not notify the human resources department. The foreman then forged the worker’s siAgnpatuaregonotimePcaDrdFs andEwnorkhtiacknetscaned,rwhen giving out the checks, diverted the payroll checks drawn from the discharged worker to his own use. The most effective procedure for preventing this activity is to

(1) require written authorization for all employees added to or removed from the payroll.

(2) haveapaymasterwhohasnootherpayrollresponsibilitydistributethepayrollchecks.

(3) have someone other than persons who prepare or distribute the payroll obtain

custody of unclaimed payroll checks.

(4) from time to time, rotate persons distributing the payroll.

b. An auditor found that employee time records in one department are not properly approved by the supervisor. Which of the following could result?

(1) Duplicate paychecks might be issued.

(2) The wrong hourly rate could be used to calculate gross pay.

(3) Employees might be paid for hours they did not work.

(4) Payroll checks might not be distributed to the appropriate employees.

c. The purpose of segregating the duties of hiring personnel and distributing payroll checks is to separate the

(1) human resource function from the controllership function.

(2) administrative controls from the internal accounting controls.

(3) authorization of transactions from the custody of related assets. (4) operational responsibility from the record-keeping responsibility.

20-18 (Objective 20-3) The following questions concern audit testing of the payroll and personnel cycle. Choose the best response.

a. When control risk is assessed as low for assertions related to payroll, substantive tests of payroll balances most likely would be limited to applying analytical procedures and (1) observing the distribution of payroll checks.

(2) footing and crossfooting the payroll register.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

(3) inspecting payroll tax returns.

(4) recalculating payroll accruals.

b. A common audit procedure in the audit of payroll transactions involves tracing

selected items from the payroll journal to employee time cards that have been approved by supervisory personnel. This procedure is designed to provide evidence in support of the audit proposition that

(1) only proper employees worked and their pay was correctly computed.

(2) jobs on which employees worked were charged with the appropriate labor cost. (3) internal controls over payroll disbursements are operating effectively.

(4) all employees worked the number of hours for which their pay was computed.

c. In performing tests concerning the granting of stock options, an auditor should

(1) confirm the transaction with the Secretary of State in the state of incorporation. (2) verifytheexistenceofoptionholdersintheentity’spayrollrecordsorstockledgers. (3) determinethatsufficienttreasurystockisavailabletocoveranynewstockissued. (4) trace the authorization for the transaction to a vote of the board of directors.

DISCUSSION QUESTIONS AND PROBLEMS

20-19 (Objectives 20-2, 20-3) Items 1 through 8 are selected questions typically found in internal control questionnaires used by auditors to obtain an understanding of internal control in the payroll and personnel cycle. In using the questionnaire for a client, a “yes” response to a question indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Does an appropriate official authorize initial rates of pay and any subsequent changes in rates?

2. Are formal records such as time cards used for keeping time?

3. Is approval by a department head or foreman required for all time cards before they

are submitted for payment?

4. Does anyone verify pay rates, overtime hours, and computations of gross payroll

before payroll checks are prepared?

5. Does an adequate means exist for identifying jobs or products, such as work orders,

job numbers, or some similar identification provided to employees to ensure proper

coding of time records?

6. Is the issuance of payments to employees independent of timekeeping?

7. Are employees required to show identification to receive paychecks?

8. Are written notices required documenting reasons for termination?

a. For each of the questions, state the transaction-related audit objective(s) being ful- Required filled if the control is in effect.

b. For each control, list a test of control to test its effectiveness.

c. For each of the questions, identify the nature of the potential financial misstate-

ment(s) if the control is not in effect.

d. For each of the potential misstatements in part c, list a substantive audit procedure for

determining whether a material misstatement exists.

20-20 (Objectives 20-2, 20-3) Following are some of the tests of controls and substantive tests of transactions procedures often performed in the payroll and personnel cycle. (Each procedure is to be done on a sample basis.)

1. Reconcile the monthly payroll total for direct manufacturing labor with the labor cost distribution.

2. Examine the time card for the approval of a foreman.

3. Recompute hours on the time card and compare the total with the total hours for

which the employee has been paid.

4. Compare the employee name, date, check number, and amounts on cancelled checks

with the payroll journal.

5. Trace the hours from the employee time cards to job tickets to make sure that the

total reconciles and trace each job ticket to the job-cost record.

Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 675

676

Required

6. Account for a sequence of payroll checks in the payroll journal.

7. Select employees from the personnel file who have been terminated, and determine whether their termination pay was in accordance with the union contract. As part of this procedure, examine two subsequent periods to determine whether the termi-

nated employee is still being paid.

a. Identify whether each of the procedures is primarily a test of control or a substantive

test of transactions.

b. Identify the transaction-related audit objective(s) of each of the procedures.

20-21 (Objectives 20-2, 20-3) The following misstatements are included in the accounting records of Lathen Manufacturing Company:

1. Joe Block and Frank Demery take turns “punching in” for each other every few days. The absent employee comes in at noon and tells his foreman that he had car trouble or some other problem. The foreman does not know that the employee is getting paid for the time.

2. The foreman submits a fraudulent time card for a former employee each week and delivers the related payroll check to the employee’s house on the way home from work. They split the amount of the paycheck.

3. Employees often overlook recording their hours worked on job-cost tickets as required by the system. Many of the client’s contracts are on a cost-plus basis.

4. Direct labor was unintentionally charged to job 620 instead of job 602 by the payroll clerk when he key-entered the labor distribution sheets. Job 602 was completed and the costs were expensed in the current year, whereas job 620 was included in work- in-process.

5. The payroll clerk prepares a check to the same nonexistent person every week when

he enters payroll transactions in the computer system, which also records the

amount in the payroll journal. He submits it along with all other payroll checks for

signature. When the checks are returned to him for distribution, he takes the check

Required

7. The payroll clerk manually prepares payroll checks but often forgets to record one or two checks in the computer-prepared payroll journal.

a. For each misstatement, state a control that should have prevented it from occurring on a continuing basis.

b. For each misstatement, state a substantive audit procedure that could uncover it.

20-22 (Objectives 20-3, 20-4, 20-5) The following audit procedures are typical of those found in auditing the payroll and personnel cycle:

1. Scan journals for all periods for unusual transactions to determine whether they are recorded correctly.

2. Select a sample of 40 entries in the payroll journal and trace each to an approved time card.

3. Discuss with management any payroll liabilities recorded in the prior year that are not provided for in the current period.

4. Examine evidence that payroll hours and wage rates are verified by an independent person.

5. Obtain a schedule of all payroll liabilities and trace to the general ledger.

6. Select a sample of 20 cancelled payroll checks and account for the numerical sequence. 7. Foot and cross-foot the payroll journal for two periods and trace totals to the general

ledger.

8. Compute payroll tax expense as a percentage of total wages, salaries, and commissions. 9. Select a sample of 20 payroll payments and trace to payroll journal entries for name,

date, and amounts.

10. Compute direct labor, indirect labor, and commissions as a percentage of net sales

and compare with prior years.

and deposits it in a special bank account bearing that person’s name.

6. In withholding payroll taxes from employees, the computer operator deducts $.50 extra federal income taxes from several employees each week and credits the amount to his own employee earnings record.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

11. Examine owner approval of rates of pay and withholdings.

12. For payroll liabilities, examine subsequent cash disbursements and supporting

documents such as payroll tax returns, depository receipts, and tax receipts.

a. Select the type of test for each audit procedure from the following:

(1) Test of control (3) Analytical procedure

(2) Substantive test of transactions (4) Test of details of balances

b. For each test of control or substantive test of transactions, identify the applicable transaction-related audit objective(s).

c. For each test of details of balances, identify the applicable balance-related audit objective(s).

20-23 (Objectives 20-3, 20-5) The following are steps in the methodology for designing tests of controls, substantive tests of transactions, and tests of details of balances for the payroll and personnel cycle:

1. Design tests of details of balances for the payroll and personnel cycle.

2. Evaluate risk and materiality for payroll expense and liability accounts.

3. Evaluate whether control risk can be assessed as low for payroll.

4. Design and perform payroll- and personnel-related analytical procedures.

5. Identify controls and deficiencies in internal control for the payroll and personnel

cycle.

6. Obtain an understanding of the payroll and personnel cycle internal controls.

7. Evaluate tests of controls and substantive tests of transactions results.

8. Design payroll and personnel cycle tests of controls and substantive tests of transactions. 9. Assess inherent risk for payroll-related accounts.

a. Identify (1) those steps that are tests of controls or substantive tests of transactions and (2) those that are tests of details of balances.

b. Put steps that are tests of controls and substantive tests of transactions in the order of

their performance in most audits.

Required

c. Put the tests of details of balances in their proper order.

20-24 (Objective 20-4) In comparing total payroll tax expense with that of the preceding year, Merlin Brendin, CPA, observed a significant increase, even though the total number of employees increased only from 175 to 185. To investigate the difference, he selected a large sample of payroll disbursement transactions and carefully tested the withholdings for each employee in the sample by referring to federal and state tax withholding schedules. In his test, he found no exceptions; therefore, he concluded that payroll tax expense was fairly stated.

a. Evaluate Brendin’s approach to testing payroll tax expense.

b. Discuss a more suitable approach for determining whether payroll tax expense is correctly stated for the year.

20-25 (Objective 20-3) You are assessing internal control in the audit of the payroll and personnel cycle for Rogers Products Company, a manufacturing company specializing in assembling computer parts. Rogers employs approximately two hundred hourly and thirty salaried employees in three locations. Each location has one foreman who is responsible for overseeing operations. The owner of the company lives in Naples, Florida and is not actively involved in the business. The two key executives are the vice president of sales and con- troller, and both have been employed by the company for more than fifteen years.

New hourly employees are hired by the foremen at each location on an as needed basis. Each foreman recommends the wage rate for each new employee as well as wage rate increases. The effectiveness of employees varies considerably and their wages are adjusted accord- ingly. All wage rates are approved by the controller.

Since each hourly employee works independently, Rogers has a highly flexible work schedule policy, as long as they start after 7:00 a.m. and are finished by 6:00 p.m. Each foreman has a supply of prenumbered time cards that they distribute to employees on Monday morning. Because some employees do not start until later in the day several time

Required

Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 677

Required

678

Required

cards are kept in a box by the time clock for their use. Hourly employees use time clocks to record when they start and stop working. Each Friday, after the employees complete their work for the week, the foremen account for the time cards they distributed, approve them, and send them by an overnight courier to the main office in Cincinnati.

The payroll clerk receives the time cards on Saturday and enters the information using payroll software that prepares the checks or direct deposit authorizations and the related payroll records. The checks are ready for the controller to sign Monday morning. She compares each check to the payroll transactions list sent by the payroll department and returns the checks using the same courier to each location. The foremen pick up the checks and distribute each check to the appropriate employee. If an employee is not present at the end of the day the foreman mails it to the employee’s address.

Except for the foremen, all salaried employees work in the Cincinnati office. The vice president of sales or controller hires all salaried employees, depending on their responsi- bilities, and determines their salaries and salary adjustments. The owner determines the salary of the vice president of sales and controller. The payroll clerk also processes the payroll transactions for salaried employees using the same payroll software that is used for hourly employees, but all salaried employees use direct deposit so no check is prepared.

The payroll software has access controls that are set by the controller. She is the only person who has access to the salary and wage rate module of the software. She updates the software for new wage rates and salaries and changes of existing ones. The accounting clerk has access to all other payroll modules. The controller’s assistant has been taught to reconcile bank accounts and does the reconciliation monthly.

a. Identify the internal control deficiencies in the Rogers Products Company’s payroll system. b. For each deficiency, state the type of misstatement that is likely to result. Be as specific as possible in describing the nature of the misstatement. If the potential misstatement

involves fraud, identify who is most likely to perpetuate the fraud.

Required

2. An employee adds 10 overtime hours that she did not work to her time record each pay period.

3. Two factory employees have an arrangement that one of them will take each Friday off, and the other employee will record their time worked so that the absent employee will be paid.

4. A supervisor does not notify human resources that an hourly employee has left the company. He continues to submit time records for the employee. The money is directly deposited in the former employee’s bank account, and he splits the amount paid with the supervisor.

5. The payroll clerk increased his salary by $100 each pay period. After a few weeks, he also increased the hourly rate for his friend who works in the shipping department.

a. For each misappropriation, indicate the transaction-related audit objective that was not met.

b. Indicate one or more controls that would be most effective in preventing or detecting the misappropriation.

c. Because the controller is concerned about fictitious employees, she has recommended a surprise payroll payoff. Which misappropriations would be detected by the surprise payroll payoff? How is the payoff done if employees do not receive payroll checks because payment is directly deposited into their bank accounts?

20-27 (Objective 20-4) Archer Uniforms, Inc., is a distributor of professional uniforms to retail stores that sell work clothing to professionals, such as doctors, nurses, security guards, etc. Traditionally, most of the sales are to retail stores throughout the United States and Canada. Most shipments are processed in bulk for delivery directly to retail stores or to the corporate office warehouse distribution facilities for retail store chains. In early 2011, Archer Uniforms began offering the sale of uniforms directly to professionals through its company Web site.

20-26 (Objective 20-3) The following are various asset misappropriations involving the payroll and personnel cycle.

1. The payroll clerk submitted payroll information for a fictitious employee and had the funds directly deposited to a bank account that he controlled.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

Professionals can access online information about uniform styles, sizes, and prices. Purchases are applied to the customer’s personal credit card, and the credit card agencies wire funds to Archer’s bank account periodically throughout the month. Management made this decision based on its conclusion that the online sales would tap a new market of professionals who do not have easy access to retail stores. Thus, the volume of shipments to retail stores is expected to remain consistent.

Because Archer’s IT staff lacked the necessary experience to create and support the online sales system, management engaged an information technology consulting firm to design and maintain the online sales system.

Before performing analytical procedures related to the payroll and personnel cycle accounts, develop expectations of how these recent events at Archer Uniforms, Inc., will affect payroll expense for the following departments during 2011 compared to prior years. Indicate the degree (extensive, moderate, little) to which you expect the payroll expense account balance to increase or decrease during 2011.

Required

1. Warehouse and Shipping Department 2. IT Department

3. Accounts Receivable Department

4. Accounts Payable Department

5. Receiving Department 6. Executive Management 7. Marketing

20-28 (Objectives 20-4, 20-5) During the first-year audit of Jones Wholesale Stationery, you observe that commissions amount to almost 25 percent of total sales, which is somewhat higher than in previous years. Further investigation reveals that the industry typically has larger sales commissions than Jones and that there is significant variation in rates depending on the product sold.

At the time a sale is made, the salesperson records the commission rate and the total amount

of the commissions on the office copy of the sales invoice. When sales are entered into the

computer system for the recording of sales, the debit to sales commission expense and credit to

accrued sales commission are also recorded. As part of recording the sales and sales commission

expense, the accounts receivable clerk verifies the prices, quantities, commission rates, and all

calculations on the sales invoices. Both the accounts receivable and the salesperson’s master files are updated when the sale and sales commission are recorded. On the fifteenth day after the end of the month, the salesperson is paid for the preceding month’s sales commissions.

a. Develop an audit program to verify sales commission expense, assuming that no audit tests have been conducted in any audit area to this point.

b. Develop an audit program to verify accrued sales commissions at the end of the year, assuming that the tests you designed in part a resulted in no significant misstatements.

Required

CASE

20-29 (Objective 20-3) Roost and Briley, CPAs, are doing the audit of Leggert Lumber Co., an international wholesale lumber broker. Because of the nature of their business, payroll and telephone expense are the two largest expenses.

You are the in-charge auditor on the engagement responsible for writing the audit program for the payroll and personnel cycle. Leggert Lumber uses a computer service company to prepare weekly payroll checks, update earnings records, and prepare the weekly payroll journal for its 30 employees. The president maintains all human resource files, knows every employee extremely well, and is a full-time participant in the business.

All employees, except the president, check into the company building daily using a time clock. The president’s secretary, Mary Clark, hands out the time cards daily, observes employees clocking in, collects the cards, and immediately returns them to the file. She goes through the same process when employees clock out on their way home.

At the end of each week, employees calculate their own hours. Clark rechecks those hours, and the president approves all time cards. Each Tuesday, Clark submits payroll input to the computer service center. She files a copy of the input data, which includes the following information for each employee:

Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 679

 

680

Information

Employee name

Social Security number Hourly labor rate*

Regular hours

Overtime hours

Special deductions*

W-4 information* Termination of employment*

Source

Time card

Employee list

Wage rate list (approved by president) Time card

Time card

Special form (prepared by employee) W-4 form

President

*Included on input form only for new employees, terminations, and changes.

The service center uses the payroll data to update master files, and print out payroll checks and a payroll register. The payroll register has the following headings:

Employee name

Social Security number Regular hours Overtime hours Regular payroll dollars

Overtime payroll dollars Gross payroll

FICA taxes withheld Medicare withheld Federal taxes withheld

State taxes withheld Other deductions Net pay

Check number

Required

A line is prepared for each employee and the journal is totaled.

Payroll checks and the journal are delivered to Clark, who compares the information on the journal with her payroll input and initials the journal. She gives the checks to the president, who signs them and personally delivers them to employees.

Clark re-adds the journal and posts the totals to the ledger. Bank statements with copies of cancelled checks are mailed to the president, and he prepares a monthly bank reconciliation.

a. Is there any loss of documentation because of the computer service center? Explain.

b. For each transaction-related audit objective for the payroll and personnel cycle, write appropriate tests of controls and substantive tests of transactions audit procedures. Consider both controls and deficiencies in writing your program. Label each procedure asAeipthear agteost ofPcoDntrFol orEa nsubhstantnivectestrof transactions.

c. Rearrange your design format audit program in requirement b into a performance format audit program.

d. Prepare a sampling data sheet using either nonstatistical or attributes sampling, such as the ones shown in Chapter 15, for the audit program in part b. Set ARACR and other factors required for sampling as you consider appropriate. Do not assume that you actually performed any tests.

INTERNET PROBLEM 20-1:

RISKS OF OUTSOURCING THE PAYROLL FUNCTION

Required

Outsourcing the payroll function can provide many benefits, but there are also risks associated with outsourcing. The IRS (www.irs.gov) provides information on outsourcing payroll duties for employers who outsource the payroll function (search for “payroll outsourcing”). The IRS also provides information on employment tax fraud investigations (search for “employment tax fraud”).

a. If the third party makes the payroll tax payments, are they responsible for any defi- ciencies or failure to make payments?

b. What should be the employer address used for correspondence with the IRS? Why do you think this provision exists?

c. Read the fiscal year 2009 investigation entitled “Former Owner of Payroll Company Sentenced to 10 Years in Prison.” What was the number of clients and the amount of payroll taxes that this payroll operator was charged with failing to remit.

d. Review other investigations in 2010 and 2009. Are there other cases of fraud involving payroll service providers?

Chapter 21

REVIEW QUESTIONS

21-1 (Objective 21-1) Give the reasons why inventory is often the most difficult and time- consuming part of many audits.

21-2 (Objectives 21-1, 21-7) Explain the relationship between the acquisition and payment cycle and the inventory and warehousing cycle in the audit of a manufacturing company. List several audit procedures in the acquisition and payment cycle that support your explanation.

21-3 (Objectives 21-1, 21-3) State what is meant by cost accounting records and explain their importance in the conduct of an audit.

21-4 (Objectives 21-3) Many auditors assert that certain audit tests can be significantly reduced for clients with adequate perpetual records that include both unit and cost data. What are the most important tests of the perpetual records that the auditor must make before reducing assessed control risk? Assuming the perpetuals are determined to be accurate, which tests can be reduced?

21-5 (Objective 21-5) Before the physical examination, the auditor obtains a copy of the client’s inventory instructions and reviews them with the controller. In obtaining an under- standing of inventory procedures for a small manufacturing company, these deficiencies are identified: Shipping operations will not be completely halted during the physical examination, and there will be no independent verification of the original inventory count by a second counting team. Evaluate the importance of each of these deficiencies and state its effect on the auditor’s observation of inventory.

21-6 (Objective 21-5) At the completion of an inventory observation, the controller requested the auditor to give him a copy of all recorded test counts to facilitate the correction of all discrepancies between the client’s and the auditor’s counts. Should the auditor comply with the request? Why?

21-7 (Objective 21-5) What major audit procedures are involved in testing for the owner-

ship of inventory during the observation of the physical counts and as a part of subsequent valuation tests?

21-8 (Objectives 21-4, 21-5, 21-6) In the verification of the amount of the inventory, one of the auditor’s concerns is that slow-moving and obsolete items be identified. List the auditing procedures that can be used to determine whether slow-moving or obsolete items have been included in inventory.

21-9 (Objective 21-5) During the taking of physical inventory, the controller intentionally withheld several inventory tags from the employees responsible for the physical count. After the auditor left the client’s premises at the completion of the inventory observation, the controller recorded nonexistent inventory on the tags and thereby significantly over- stated earnings. How could the auditor have uncovered the misstatement, assuming that there are no perpetual records?

21-10 (Objective 21-5) Explain why a proper cutoff of purchases and sales is heavily dependent on the physical inventory observation. What information should be obtained during the physical count to make sure that cutoff is accurate?

21-11 (Objective 21-6) Define what is meant by compilation tests. List several examples of audit procedures to verify compilation.

21-12 (Objective 21-4) List the major analytical procedures for testing the overall reason- ableness of inventory. For each test, explain the type of misstatement that could be identified.

21-13 (Objective 21-6) Included in the December 31, 2011, inventory of the Wholeridge Supply Company are 2,600 deluxe ring binders in the amount of $5,902. An examination of the most recent acquisitions of binders showed the following costs: January 26, 2012, 2,300 at $2.42 each; December 6, 2011, 1,900 at $2.28 each; November 26, 2011, 2,400 at $2.07 each. What is the misstatement in valuation of the December 31, 2011, inventory for deluxe ring binders, assuming FIFO inventory valuation? What would your answer be if the January 26, 2012, acquisition was for 2,300 binders at $2.12 each?

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

21-14 (Objectives 21-6, 21-7) The Ruswell Manufacturing Company applied manufac- turing overhead to inventory at December 31, 2011, on the basis of $3.47 per direct labor hour. Explain how you will evaluate the reasonableness of total direct labor hours and manufacturing overhead in the ending inventory of finished goods.

21-15 (Objective 21-7) Each employee for the Gedding Manufacturing Co., a firm using a job-cost inventory costing method, must reconcile his or her total hours worked with the hours worked on individual jobs using a job time sheet at the time weekly payroll time cards are prepared. The job time sheet is then stapled to the time card. Explain how you could test the direct labor dollars included in inventory as a part of the payroll and personnel tests.

21-16 (Objective 21-5) Assuming that the auditor properly documents receiving report numbers as a part of the physical inventory observation procedures, explain how the proper cutoff of purchases, including tests for the possibility of raw materials in transit, should be verified later in the audit.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

21-17 (Objective 21-1) The following questions concern internal controls in the inventory and warehousing cycle. Choose the best response.

a. Which of the following controls will most likely justify a reduced assessed level of control risk for the occurrence assertion for purchases of inventory?

(1) Receiving reports for inventory additions are accounted for and entry of received

goods into the purchases system is verified by accounting clerks.

(2) The purchases system automatically updates the perpetual inventory master file

when transactions are entered into the purchases journal.

(3) The perpetual inventory system will not allow an addition of inventory to be

 

posted without entry of a valid receiving report number.

(4) At the close of each day, the system reconciles the perpetual inventory master file to the inventory general ledger account and generates an exception report when differences exist.

b. For

copy of the purchase order that is

(1) returned to the requisitioner.

(2) forwarded to the receiving department.

(3) forwarded to the accounting department.

(4) retained in the purchasing department’s files.

c. Which of the following procedures will best detect the theft of valuable items from an inventory that consists of hundreds of different items selling for $1 to $10 and a few items selling for hundreds of dollars?

(1) Maintain a perpetual inventory master file of only the more valuable items with

frequent periodic verification of the validity of the perpetuals.

(2) Have an independent CPA firm prepare an internal control report on the effec-

tiveness of the administrative and accounting controls over inventory.

(3) Have separate warehouse space for the more valuable items with sequentially

numbered tags.

(4) Require an authorized officer’s signature on all requisitions for the more valuable

items.

21-18 (Objectives 21-1, 21-3) The following questions concern testing the client’s internal controls for inventory and warehousing. Choose the best response.

a. When an auditor tests a client’s cost accounting records, the auditor’s tests are pri- marily designed to determine that

(1) costshavebeencorrectlyassignedtofinishedgoods,work-in-process,andcostof

control purposes, the quantities of materials ordered may be omitted from the

goods sold.

Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 701

702

(2) quantities on hand have been computed based on acceptable cost accounting techniques that reasonably approximate actual quantities on hand.

(3) physical inventories are in substantial agreement with book inventories.

(4) the internal controls are in accordance with accounting standards and are

functioning as planned.

b. The accuracy of perpetual inventory master files may be established, in part, by com- paring perpetual inventory records with

(1) purchase requisitions. (3) purchase orders.

(2) receiving reports. (4) vendor payments.

c. Which of the following sets of duties related to inventory and warehousing causes the greatest concern about inadequate segregation of duties?

(1) Individuals in charge of approving disbursements related to inventory purchases

have “read-only” ability to view the list of vendors in the pre-approved vendor

master file.

(2) Purchasing agents who arrange for shipment of raw materials from vendors are

responsible for verifying actual receipt of the inventory items at the receiving dock.

(3) Thereceivingdepartmenthasaccesstocopiesofthepurchaseordersthatexclude

information about quantities ordered.

(4) Accountspayablepersonnelhaveaccesstoreceivingreportsandpurchasesorders

in addition to vendor invoices for inventory purchases.

21-19 (Objectives 21-1, 21-4, 21-5, 21-6) The following questions deal with tests of details of balances and analytical procedures for inventory. Choose the best response.

a. Which of the following procedures is the auditor least likely to perform on the actual date the physical inventory count is observed?

(1) Examine inventory to make sure that it is tagged by client count teams.

(2) Watch for inventory items that are rust- or dust-covered or otherwise damaged. (3) Observe client count teams to determine if they are conducting the physical

Apinvaengtoory coPunDt inFaccoErdnanhceawinthclientrpolicies and procedures.

(4) Examine documentation supporting the acquisition of highly material inventory

items on hand at the count date.

b. An inventory turnover analysis is useful to the auditor because it may detect (1) inadequacies in inventory pricing.

(2) methods of avoiding cyclical holding costs.

(3) the existence of obsolete merchandise.

(4) the optimum automatic reorder points.

c. A CPA auditing inventory may appropriately apply attributes sampling to estimate the (1) average price of inventory items.

(2) percentage of slow-moving inventory items.

(3) dollar value of inventory.

(4) physical quantity of inventory items.

DISCUSSION QUESTIONS AND PROBLEMS

21-20 (Objectives 21-1, 21-3, 21-5, 21-6, 21-7) Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an understanding of internal control in the inventory and warehousing cycle. In using the questionnaire for a client, a “yes” response to a question indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Is a detailed perpetual inventory master file maintained for raw materials inventory?

2. Are physical inventory counts made by someone other than storekeepers and those

responsible for maintaining the perpetual inventory master file?

3. Is the clerical accuracy of the final inventory compilation checked by a person

independent of those responsible for preparing it?

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

4. Does the receiving department prepare prenumbered receiving reports and account for the numbers periodically for all inventory received, showing the description and quantity of materials?

5. Is all inventory stored under the control of an inventory custodian in areas where access is limited?

6. Are all shipments to customers authorized by prenumbered shipping documents?

7. Are standard cost records used for raw materials, direct labor, and manufacturing

overhead?

8. Is there a stated policy with specific criteria for writing off obsolete or slow-moving

goods?

a. For each of the preceding questions, state the purpose of the internal control.

b. For each internal control, list a test of control to test its effectiveness.

c. For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect.

d. For each of the potential misstatements in part c, list a substantive audit procedure to determine whether a material misstatement exists.

21-21 (Objective 21-1, 21-3, 21-5, 21-6, 21-7) The Frist Corporation has the following internal controls related to inventory:

1. The inventory purchasing system only allows purchases from pre-approved vendors.

2. The perpetual inventory system tracks the average number of days each inventory

product number has been in the warehouse.

3. Microchips are embedded in each product and when inventory items are removed

from the warehouse to shipping, radio-frequencies signal a deduction of inventory

to the perpetual inventory system.

4. Only authorized inventory warehousing personnel are allowed in inventory storage

Required

areas.

5. All inventory products are stored in warehousing areas that are segregated from

other storage areas used to house equipment and supplies.

6. On a weekly basis, inventory accounting personnel take samples of inventory

products selected from the perpetual inventory system and verify that the inventory

is on-hand in the warehouse and that the quantities in the listing are correct.

7. On a weekly basis, inventory accounting personnel select inventory items on hand in the warehouse and verify that the item is included in the perpetual inventory listing

at the correct amount.

8. The perpetual inventory system subtotals the quantity of inventory in the system and

interfaces with the general ledger system on a daily basis to ensure quantities agree.

9. The perpetual inventory system will not accept inventory additions without the

recording on a valid receiving report.

10. All inventory held on consignment at Frist Corporation is stored in a separate area of

the warehouse.

For each of the internal controls:

a. Identify the related transaction-related audit objective(s) affected by the control. b. Describe risks the control is designed to mitigate.

c. Design a test of control to determine if the control is operating effectively.

21-22 (Objective 21-3) The cost accounting records are often an essential area to audit in a manufacturing or construction company.

a. Why should the auditor review the cost accounting records and test their accuracy?

b. For the audit of standard cost accounting records in which 35 parts are manufactured, explain how you would determine whether each of the following were reasonable for

Required

Required

part no. 21:

(1) Standard direct labor hours (2) Standarddirectlaborrate (3) Standard overhead rate

(4) Standard units of raw materials

(5) Standardcostofaunitofrawmaterials (6) Total standard cost

Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 703

704

Required

21-23 (Objectives 21-1, 21-3, 21-5, 21-6) Following are audit procedures commonly performed in the inventory and warehousing cycle for a manufacturing company:

1. Read the client’s physical inventory instructions and observe whether they are being followed by those responsible for counting the inventory.

2. Account for a sequence of inventory tags and trace each tag to the physical inventory to make sure it actually exists.

3. Compare the client’s count of physical inventory at an interim date with the perpetual inventory master file.

4. Trace the auditor’s test counts recorded in the audit files to the final inventory compilation and compare the tag number, description, and quantity.

5. Compare the unit price on the final inventory summary with vendors’ invoices.

6. Account for a sequence of raw material requisitions and examine each requisition

for an authorized approval.

7. Trace the recorded additions on the finished goods perpetual inventory master file to

the records for completed production.

a. Identify whether each of the procedures is primarily a test of control or a substantive test. b. State the purpose(s) of each of the procedures.

21-24 (Objectives 21-1, 21-5, 21-6) The following misstatements are included in the inventory and related records of Westbox Manufacturing Company:

1. An inventory item was priced at $12 each instead of at the correct cost of $12 per dozen.

2. In taking the physical inventory, the last shipments for the day were excluded from inventory and were not included as a sale until the subsequent year.

3. The clerk in charge of the perpetual inventory master file altered the quantity on an inventory tag to cover up the shortage of inventory caused by its theft during the year.

4. After the auditor left the premises, several inventory tags were lost and were not

included in the final inventory summary.

5. AWhpenaragwomatePriaDl aFcquisEitionshwaerenrecoerderd, the improper unit price was included

in the perpetual inventory master file. Therefore, the inventory valuation was mis-

stated because the physical inventory was priced by referring to the perpetual records.

6. During the physical count, several obsolete inventory items were included.

7. Because of a significant increase in volume during the current year and excellent

control over manufacturing overhead costs, the manufacturing overhead rate applied to inventory was far greater than actual cost.

a. For each misstatement, state an internal control that should have prevented it from occurring.

b. For each misstatement, state a substantive audit procedure that can be used to uncover it.

21-25 (Objective 21-3, 21-5) You are responsible for the audit of inventory for Honey Best Grocery Wholesales, Inc., a closely held grocery wholesaler that sells to independent grocery stores. Inventory is by far the largest account on their balance sheet. Honey Best operates in ten southeastern states with a central distribution center in Atlanta and local distribution centers in each of the ten states in which it operates. Management has implemented a sophisticated perpetual inventory system that includes only quantities to assist in managing quantity levels in Atlanta and the local distribution centers. All accounting is maintained in Atlanta, including purchases which originate from the Atlanta office using online inventory information available for all centers. All inventory deliveries are made to the Atlanta center and then sent to local centers, again using the online information. Product and quantity information for sales are prepared online by each distribution center for updating the perpetual records, with a hard copy sent to Atlanta. Each center takes a quarterly physical inventory for comparison to and adjustment of the perpetual records. The counts are sent to Atlanta where all adjustments are made. Regional centers’ access to the perpetual records are limited to online sales transaction entry. Internal auditors test the perpetual records continuously, sample physical inventory counts and test inventory adjustments. Their tests and results are filed in Atlanta.

Required

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

a. List six or more internal controls and tests of controls that can be used to test the effectiveness of internal controls over inventory.

b. Assuming you determine that internal controls are effective, state how you can reduce or change physical observation tests of inventory. Be specific.

21-26 (Objective 21-4) Your client, Ridgewood Heating and Cooling, specializes in resi- dential air conditioning and heating installations. The company maintains an inventory of air conditioning units, furnaces, and air handling ductwork. The client has provided the following selected financial statement information for the year ending December 31, 2011:

Required

Total Sales

Cost of Goods Sold Ending Inventory

12/31/2011

$55,443,900 47,771,880 9,582,960

12/31/2010

$52,700,440 46,810,900 8,100,220

12/31/2009

$50,384,300 44,670,400 7,730,660

Following is a breakdown of the ending inventory account as of December 31, 2011:

Inventory Description

AC Unit – Model 635 AC Unit – Model 770 Furnace – Model 223 Furnace – Model 225 Air Handling Ducts

Total

Quantity

1,240 Units 1,733 Units 1,992 Furnaces 2,008 Furnaces

11,883 Boxes

Ending Balance

$ 806,000

1,940,960

2,589,600

2,761,000

1,485,400 __________

$9,582,960

Ridgewood stores inventory in a 100,000 square foot warehouse facility at a location different

from its corporate office. A single AC unit is stored on a 4 foot by 4 foot pallet. Warehouse

storage shelves allow the company to store 1 pallet on the floor while 2 additional pallets

are placed on shelves above the first pallet. Furnaces are also stored on similar sized pallets.

Due to the height of the furnaces, only one unit can be stored on a shelf above another

pallet that rests on the floor. Air handling ducts are stored in boxes that are 5 foot by 5 foot

at the base and 7 feet tall. Three boxes can be stacked on top of the box that sits on the floor.

a. Design analytical procedures to evaluate the reasonableness of the ending inventory account.

b. What concerns, if any, do you have about the ending inventory at Ridgewood Heating and Cooling?

21-27 (Objective 21-5) You encountered the following situations during the December 31, 2011, physical inventory of Latner Shoe Distributor Company:

a. Latner maintains a large portion of the shoe merchandise in 10 warehouses through- out the eastern United States. This ensures swift delivery service for its chain of stores. You are assigned alone to the Boston warehouse to observe the physical inventory process. During the inventory count, several express trucks pulled in for loading. Although infrequent, express shipments must be attended to immediately. As a result, the employees who were counting the inventory stopped to assist in loading the express trucks. What should you do?

Required

Required

b. (1)

In one storeroom of 10,000 items, you have test-counted about 200 items of high value and a few items of low value. You found no misstatements. You also note that the employees are diligently following the inventory instructions. Do you think you have tested enough items? Explain.

(2) Whatwouldyoudoifyoutest-counted150itemsandfoundasubstantialnumber of counting errors?

c. In observing an inventory of liquid shoe polish, you note that one lot is 5 years old. From inspection of some bottles in an open box, you find that the liquid has solidified in most of the bottles. What action should you take?

d. During your observation of the inventory count in the main warehouse, you found that most of the prenumbered tags that had been incorrectly filled out are being destroyed

Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 705

706

Required

and thrown away. What is the significance of this procedure and what action should you take?

21-28 (Objective 21-5) In connection with his audit of the financial statements of Knutson Products Co., an assembler of home appliances, for the year ended May 31, 2011, Ray Abel, CPA, is reviewing with Knutson’s controller the plans for a physical inventory at the company warehouse on May 31, 2011.

Finished appliances, unassembled parts, and supplies are stored in the warehouse, which is attached to Knutson’s assembly plant. The plant will operate during the count. On May 30, the warehouse will deliver to the plant the estimated quantities of unassembled parts and supplies required for May 31 production, but there may be emergency requi- sitions on May 31. During the count, the warehouse will continue to receive parts and supplies and to ship finished appliances. However, appliances completed on May 31 will be held in the plant until after the physical inventory.

What procedures should the company establish to ensure that the inventory count includes all items that should be included and that nothing is counted twice?*

21-29 (Objective 21-4) The following are sales, cost of sales, and inventory data for Aladdin Products Supply Company, a wholesale distributor of cleaning supplies. Dollar amounts are in millions.

Required

a. Calculate the following ratios, using an electronic spreadsheet program (instructor’s option):

2011

Sales $92.8

2010 2009 2008

$86.8 $78.4 $69.6

Cost of sales Beginning inventory Ending inventory

68.4 67.2 9.2 8.4 11.6 9.2

60.8 54.0 7.6 6.0 8.4 7.6

(1) Gross margin as a percentage of sales (2) Inventory turnover b. List several logical causes of the changes in the two ratios.

c. Assume that $2,000,000 is considered material for audit planning purposes for 2011. Do any of the fluctuations in the computed ratios indicate a possible material misstatement? Demonstrate this by using the spreadsheet program to perform a sensitivity analysis.

d. What should the auditor do to determine the actual cause of the changes?

21-30 (Objective 21-5) In an annual audit at December 31, 2011, you find the following transactions near the closing date:

1. Merchandise costing $1,822 was received on January 3, 2012, and the related acquisition invoice recorded January 5. The invoice showed the shipment was made on December 29, 2011, FOB destination.

2. Merchandise costing $625 was received on December 28, 2011, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked “on consignment.”

3. A packing case containing products costing $816 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer’s order was dated December 18, 2011, but that the case was shipped and the customer billed on January 10, 2012. The product was a stock item of your client.

4. Merchandise received on January 6, 2012, costing $720 was entered in the acquisitions journal on January 7, 2012. The invoice showed shipment was made FOB supplier’s warehouse on December 31, 2011. Because it was not on hand December 31, it was not included in inventory.

5. A special machine, fabricated to order for a customer, was finished and in the shipping room on December 31, 2011. The customer was billed on that date and the machine excluded from inventory, although it was shipped on January 4, 2012.

*AICPA adapted.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

Assume that each of the amounts is material.

a. State whether the merchandise should be included in the client’s inventory. b. Give your reason for your decision on each item.*

21-31 (Objective 21-6) As a part of your clerical tests of inventory for Martin Manufac- turing, you have tested about 20% of the dollar items and have found the following exceptions:

Required

1. Extension errors:

Description

Wood Metal-cutting tools Cutting fluid Sandpaper

Quantity

920 board feet 49 units

26 barrels

600 sheets

Price

$ 0.12/board foot 30.00 each 40.00/barrel

0.95/hundred

Extension as Recorded

$ 11.04 1,740.00 240.00 579.00

2. Differences located in comparing last year’s costs with the current year’s costs on the client’s inventory lists:

Description

TA-114 precision-cutting torches Aluminum scrap

Lubricating oil

Quantity

12 units 4,500 pounds 400 gallons

This Year’s Cost

$800.00 each 8.00/ton

55.00/gallon

Preceding Year’s Cost

Unable to locate $95.00/ton

95.00/barrel

3. Test counts that you were unable to find when tracing from the test counts to the final inventory compilation:

Tag No.

2958 0026

Quantity

20 tons 3,000 feet

Current Year Cost

$75.00/ton 2.25/foot

Description

Cold-rolled bars

4-inch aluminum stripping

Correct Total

4. Page total, footing errors:

Page No.

14 82

a. State the amount of the actual misstatement in each of the four tests. For any item for which the amount of the misstatement cannot be determined from the information given, state the considerations that will affect your estimate of the misstatement.

b. As a result of your findings, what will you do about clerical accuracy tests of the inventory in the current year?

c. What changes, if any, would you suggest in internal controls and procedures for Martin Manufacturing during the compilation of next year’s inventory to prevent each type of misstatement?

21-32 (Objective 21-5) You have been engaged for the audit of the Y Company for the year ended December 31, 2011. The Y Company is in the wholesale chemical business and makes all sales at 25% over cost.

Following are portions of the client’s sales and purchases accounts for the calendar year

2011.

Date

12-31

SALES

Balance Forward

Date Reference Amount

Client Total

 

$2,375.36 $2,375.30

6,721.18 6,421.18

Required

Reference

Closing entry

Amount

$699,860

_________ $699,860

$658,320

5,195

19,270

1,302

5,841

7,922

2,010 _________

$699,860

12-27 12-28 12-28 12-31 12-31 12-31

*SI#965 SI#966 SI#967 SI#969 SI#970 SI#971

*SI = Sales invoice.

*AICPA adapted.

Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 707

708

Required

CASE

966, and the terms were FOB destination.

5. En route to the Y Company on December 31, 2011 was a truckload of material that

was received on receiving report no. 1064. The material was shipped FOB desti- nation, and freight of $75 was paid by the Y Company. However, the freight was deducted from the purchase price of $975.

6. Included in the physical inventory were chemicals exposed to rain during transit and deemed unsalable. Their invoice cost was $1,250, and freight charges of $350 had been paid on the chemicals.

a. Compute the adjustments that should be made to the client’s physical inventory at December 31, 2011.

b. Prepare a worksheet of adjusting entries that are required as of December 31, 2011.*

Date

12-28 12-30 12-31 12-31

Balance Forward

Reference

†RR#1059 RR#1061 RR#1062 RR#1063

Amount

$360,300

3,100

8,965

4,861

8,120 _________

$385,346

Date

12-31

Reference

Closing entry

Amount

$385,346

_________ $385,346

PURCHASES

†RR = Receiving report.

You observed the physical inventory of goods in the warehouse on December 31, 2011, and were satisfied that it was properly taken.

When performing a sales and purchases cutoff test, you found that at December 31, 2011, the last receiving report that had been used was no. 1063 and that no shipments have been made on any sales invoices with numbers larger than no. 968. You also obtained the following additional information:

1. Included in the warehouse physical inventory at December 31, 2011 were chemicals that had been acquired and received on receiving report no. 1060 but for which an invoice was not received until the year 2012. Cost was $2,183.

2. In the warehouse at December 31, 2011 were goods that had been sold and paid for by the customer but which were not shipped out until the year 2012. They were all sold on sales invoice no. 965 and were not inventoried.

3. On the evening of December 31, 2011 there were two cars on the Y company siding: (a) CarAR38162wasunloadedonJanuary2,2012,andreceivedonreceivingreport

no. 1063. The freight was paid by the vendor.

(b) Car BAE74123 was loaded and sealed on December 31, 2011, and was switched

off the company’s siding on January 2, 2012. The sales price was $12,700 and the

freight was paid by the customer. This order was sold on sales invoice no. 968. 4. Temporarily stranded at December 31, 2011 on a railroad siding were two cars of chemicals en route to the Z Pulp and Paper Co. They were sold on sales invoice no.

21-33 (Objective 21-6) You are assigned to the December 31, 2011, audit of Sea Gull Airframes, Inc. The company designs and manufactures aircraft superstructures and airframe components. You observed the physical inventory at December 31 and are satisfied that it was properly taken. The inventory at December 31, 2011, has been priced, extended, and totaled by the client and is made up of about 5,000 inventory items with a total valuation of $8,275,000. In performing inventory price tests, you have decided to

*AICPA adapted.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

stratify your tests and conclude that you should have two strata: items with a value over $5,000 and those with a value of less than $5,000. The book values are as follows:

No. of Items

More than $5,000 500

Less than $5,000 4,500 _____

5,000

Total Value

$4,150,000

4,125,000 __________

$8,275,000

In performing pricing and extension tests, you have decided to test about 50 inventory items in detail. You selected 40 of the over $5,000 items and 10 of those under $5,000 at random from the population. You find all items to be correct except for items A through G below, which you believe may be misstated. You have tested the following items, to this point, exclusive of A through G:

No. of Items

More than $5,000 36 Less than $5,000 7

Total Value

$360,000 2,600

Sea Gull Airframes uses a periodic inventory system and values its inventory at the lower of FIFO cost or market. You were able to locate all invoices needed for your examination. The seven inventory items in the sample you believe may be misstated, along with the relevant data for determining the proper valuation, are shown next.

INVENTORY ITEMS POSSIBLY MISSTATED

Description

A. L37 spars

B. B68 metal formers

C. R01 metal ribs

D. St26 struts

E. Industrial hand drills

F. L803 steel leaf springs

G. V16 fasteners

Quantity

3,000 meters 10,000 inches

1,500 yards 1,000 feet

Price

$ 8.00/meter 1.20/foot 10.00/yard 8.00/foot

20.00 each

69.00 each spring

Total1

$24,000 12,000 15,000

8,000

900

45 units 40 pairs

276

5.50 dozen 10.00/dozen 55

1Amounts are as stated on client’s inventory.

Voucher Number

7-68 11-81

12-06 12-09

12-18 12-23 12-61

12-81

Voucher Date

8-01-06 10-16-11

12-08-11 12-10-11

12-27-11 12-24-11 12-29-11

12-31-11

INFORMATION FOR PRICING FROM INVOICES (SEA GULL AIRFRAMES) Receiving

Date Paid

8-21-06 11-15-11

12-30-11 12-18-11

12-27-11 1-03-12 1-08-12

1-20-12

Terms

Net FOB destination Net FOB destination

2/10, n/30 FOB S.P. Net FOB destination

2/10, n/30 FOB S.P. 2/10, n/30 FOB dest. Net FOB destination

Net FOB destination

Report Date

8-01-06 10-18-11

12-10-11 12-11-11

12-21-11 12-26-11 12-29-11

1-06-12

Invoice Description

77 V16 fasteners at $10 per dozen

1,100 yards R01 metal ribs at $9.50 per yard; 2,000 feet St26 struts at $8.20 per foot

180 L803 steel leaf springs at $69 each

45 industrial hand drills at $20 each; guaranteed for 4 years

4,200 meters L37 spars at $8 per meter

12,800 inches B68 metal formers at $1.20 per foot

1,000 yards R01 metal ribs at $10 per yard; 800 feet St26 struts at $8 per foot

2,000 meters L37 spars at $7.50 per meter; 2,000 yards R01 metal ribs at $10 per yard

In addition, you noted a freight bill for voucher 12-23 in the amount of $200. This bill was entered in the freight-in account. Virtually all freight was for the metal formers.

This is the first time Sea Gull Airframes has been audited by your firm.

a. Review all information and determine the inventory misstatements of the seven items in question. State any assumptions you consider necessary to determine the amount of the misstatements.

Required

Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE

709

 

710

b. Prepare an audit schedule to summarize your findings. Use the computer to prepare the schedule (instructor’s option).

INTERNET PROBLEM 21-1:

USING INVENTORY COUNT SPECIALISTS

Required

Since 1938, when auditors failed to uncover fictitious inventory recorded by the McKesson & Robbins Company, auditors have been ordinarily required to physically observe the counting of inventory. It is important to recognize that auditors are not required to actually count the inventory for inclusion on the balance sheet, but they are required to observe the inventory being counted. Occasionally, companies employ inventory specialists to perform their inventory counts. One very large inventory counting specialist is Retail Grocery Inventory Service, now known as RGIS. Visit RGIS’s (www.rgisinv.com) Web site and answer the following questions.

a. Under the link to “Case Studies,” read the case about Hines Horticulture. How did RGIS assist Hines in its inventory management?

b. What created the need for Hines to use a service provider such as RGIS?

c. Does an auditor’s responsibility for observing the physical inventory differ if a company hires an inventory specialist such as RGIS to perform counts as opposed to having its own employees perform inventory counts?

d. Would your expectations of the results of the physical observation of a client’s inventory change if a client hired a company such as RGIS?

e. What are the advantages and disadvantages of hiring an inventory specialist such as RGIS?

Chapter 22

REVIEW QUESTIONS

22-1 (Objective 22-1) List four examples of interest-bearing liability accounts commonly found in balance sheets. What characteristics do these liabilities have in common? How do they differ?

22-2 (Objectives 22-1, 22-2) Why are liability accounts included in the capital acquisition and repayment cycle audited differently from accounts payable?

22-3 (Objective 22-2) It is common practice to audit the balance in notes payable in conjunction with the audit of interest expense and interest payable. Explain the advantages of this approach.

22-4 (Objective 22-2) Which internal controls should the auditor be most concerned about in the audit of notes payable? Explain the importance of each.

22-5 (Objective 22-2) Which analytical procedures are most important in verifying notes payable? Which types of misstatements can the auditor uncover by the use of these tests?

22-6 (Objective 22-2) Why is it more important to search for unrecorded notes payable than for unrecorded notes receivable? Suggest audit procedures that the auditor can use to uncover unrecorded notes payable.

22-7 (Objective 22-2) What is the primary purpose of analyzing interest expense? Given this purpose, what primary considerations should the auditor keep in mind when doing the analysis?

22-8 (Objective 22-2) Distinguish between (a) tests of controls and substantive tests of transactions and (b) tests of details of balances for liability accounts in the capital acquisi- tion and repayment cycle.

22-9 (Objective 22-2) List two types of restrictions long-term creditors often put on companies when granting them a loan. How can the auditor find out about these restrictions?

22-10A(Opbjaectgivoe 22-P3)DWFhat aErenthehparimnacryeobrjectives in the audit of owners’ equity accounts?

22-11 (Objectives 22-3, 22-4) Evaluate the following statement: “The corporate charter and the bylaws of a company are legal documents; therefore, they should not be examined by the auditors. If the auditor wants information about these documents, an attorney should be consulted.”

22-12 (Objective 22-3) What are the major internal controls over owners’ equity?

22-13 (Objective 22-3) How does the audit of owners’ equity for a closely held corporation differ from that for a publicly held corporation? In what respects are there no significant differences?

22-14 (Objective 22-3) Describe the duties of a stock registrar and a transfer agent. How does the use of their services affect the client’s internal controls?

22-15 (Objective 22-4) What kinds of information can be confirmed with a transfer agent?

22-16 (Objective 22-4) Evaluate the following statement: “The most important audit procedure to verify dividends for the year is a comparison of a random sample of cancelled dividend checks with a dividend list that has been prepared by management as of the dividend record date.”

22-17 (Objective 22-4) If a transfer agent disburses dividends for a client, explain how the audit of dividends declared and paid is affected. What audit procedures are necessary to verify dividends paid when a transfer agent is used?

22-18 (Objective 22-4) What should be the major emphasis in auditing the retained earnings account? Explain your answer.

22-19 (Objectives 22-3, 22-4) Explain the relationship between the audit of owners’ equity and the calculations of earnings per share. What are the main auditing considerations in verifying the earnings per share figure?

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

22-20 (Objective 22-2) The following multiple choice questions concern interest-bearing liabilities. Choose the best response.

a. The audit program for long-term debt should include steps that require the (1) verification of the existence of the bondholders.

(2) examination of any bond trust indenture.

(3) inspection of the accounts payable master file.

(4) investigation of credits to the bond interest income account.

b. During the year under audit, a company has completed a private placement of a sub- stantial amount of bonds. Which of the following is the most important step in the

auditor’s program for the audit of bonds payable?

(1) Recomputing the annual interest cost and the effective yield.

(2) Confirming the amount issued with the bond trustee.

(3) Tracing the cash received from the issue to the accounting records. (4) Examining the bond records maintained by the transfer agent.

c. Which of the following controls will most likely justify a reduced assessed level of control risk for the completeness assertion for notes payable?

(1) The accounting staff reviews board of director minutes for any indication of any

transactions involving outstanding debt to make sure all borrowings are included

in the general ledger.

(2) Allborrowingsthatexceed$500,000requireapprovalfromtheboardofdirectors

before loan contracts can be finalized.

(3) Before approving disbursement of principal payments on notes payable, the

treasurer reviews terms in the note.

(4) Accounting maintains a detailed schedule of outstanding note payable that is

reconciled monthly to the general ledger.

d. In the audit of notes payable, which balance-related audit objective is generally one of

the most important for the auditor to verify?

(1) Notes payable reflected on the balance sheet at the end of the year exist.

(2) Notes payable due to related parties are properly reflected on the balance sheet. (3) Existing notes payable are included on the balance sheet as of year end.

(4) Notes payable are reflected at net realizable value as of the balance sheet date.

22-21 (Objectives 22-2, 22-3, 22-4) The following questions concern the audit of accounts in the capital acquisition and repayment cycle. Choose the best response.

a. During an audit of a publicly held company, the auditor should obtain written con- firmation regarding debenture transactions from the

(1) debenture holders. (3) internal auditors.

(2) client’s attorney. (4) trustee.

b. An audit program for the audit of the retained earnings account should include a step that requires verification of

(1) marketvalueusedtochargeretainedearningstoaccountfora2-for-1stocksplit.

(2) approvaloftheadjustmenttothebeginningbalanceasaresultofawrite-downof

an account receivable.

(3) authorization for both cash and stock dividends.

(4) gain or loss resulting from disposition of treasury shares.

c. Which of the following internal controls is least likely to reduce risks related to the occurrence transaction-related audit objective for issuances of stock?

(1) The board of directors must approve the distribution of cash dividends.

(2) Theissuanceofanysharesofstockmustbepre-approvedbytheboardofdirectors.

(3) The company engages an independent registrar to issue stock certificates.

(4) The company maintains a capital stock certificate record that includes certificate number, number of shares issued, issue date, and name of person to whom certifi- cates are issued.

Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 725

726

d. Which of the following audit procedures would be most relevant when examining the completeness transaction-related audit objective for capital stock?

(1) The auditor examines minutes of the board of directors’ meetings to identify any

actions involving the issuance of capital stock.

(2) The auditor vouches entries in the client’s capital stock records to board minutes.

(3) Confirmations of new stock issuances are sent to the client’s stock transfer agent.

(4) The auditor traces entries of new stock issuances to the cash receipts journal.

DISCUSSION QUESTIONS AND PROBLEMS

Required

22-22 (Objective 22-2) Items 1 through 6 are questions typically found in a standard internal control questionnaire used by auditors to obtain an understanding of internal control for notes payable. In using the questionnaire for a client, a “yes” response indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Are liabilities for notes payable incurred only after written authorization by a proper company official?

2. Is a notes payable master file maintained?

3. Is a periodic reconciliation made of the notes payable master file with the actual notes

outstanding by an individual who does not maintain the master file?

4. Is the individual who maintains the notes payable master file someone other than the

person who approves the issue of new notes or handles cash?

5. Are paid notes cancelled and retained in the company files?

6. Are interest expense and accrued interest recomputed periodically by an individual

who does not record interest transactions?

a. For each of the preceding questions, state the purpose of the control.

b. For each of the preceding questions, identify the type of financial statement misstate- mAenpt tahagt caon ocPcurDifFthe cEonntrohl waerne ncoteinreffect.

c. For each of the potential misstatements in part b, list an audit procedure that can be used to determine whether a material misstatement exists.

22-23 (Objective 22-2) The following are frequently performed audit procedures for the verification of bonds payable issued in previous years:

1. Analyze the general ledger account for bonds payable, interest expense, and unamor- tized bond discount or premium.

2. Obtain a confirmation from the bondholder.

3. Obtain a copy of the bond indenture agreement and review its important provisions.

4. Determine that each of the bond indenture provisions has been met.

5. Test the client’s calculations of interest expense, unamortized bond discount or

premium, accrued interest, and bonds payable.

a. State the purpose of each of the five audit procedures listed.

b. List the provisions for which the auditor should be alert in examining the bond indenture agreement.

c. For each provision listed in part b, explain how the auditor can determine whether its terms have been met.

d. Explain how the auditor should verify the unamortized bond discount or premium.

e. List the information that should be requested in the confirmation of bonds payable with the bondholder.

22-24 (Objective 22-2) Your client, Red Horse Inc., prepared the following schedule for long term debt for the audit of financial statements for the year ended December 31, 2011:

Required

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

a.

b. c. d. e. f .

What type of evidence would you examine to support the beginning balances in the accounts?

What types of evidence would you use to support the additions to each account? What types of evidence would you examine to support payments?

What procedures would you perform related to the ending balances in the accounts? What evidence would you use to verify interest rates and due dates?

How might you use the information presented above to audit interest expense and interest payable accounts?

Required

Notes Payable Description

Mortgage Payable Unsecured Notes

Payable Secured Bonds Convertible

Debentures

Total $11,325,000

Interest Due

Rate Date

6.25% 2020

6.00% 2022 5.75% 2018

1/1/11 Beginning Balance

$ 1,125,000

7,500,000 2,700,000

Additions

– $ 1,250,000

10,000,000 ___________

$11,250,000

Payments

$200,000

475,000 300,000

— ________

$975,000

12/31/11 Ending Balance

$ 925,000

7,025,000 3,650,000

10,000,000 ___________

$21,600,000

5.25% 2025

— ___________

22-25 (Objective 22-2) The ending general ledger balance of $186,000 in notes payable for the Sterling Manufacturing Company is made up of 20 notes to eight different payees. The notes vary in duration anywhere from 30 days to 2 years, and in amounts from $1,000 to $10,000. In some cases, the notes were issued for cash loans; in other cases, the notes were issued directly to vendors for the acquisition of inventory or equipment. The use of relatively short-term financing is necessary because all existing properties are pledged for mortgages. Nevertheless, there is still a serious cash shortage.

Record-keeping procedures for notes payable are not good, considering the large number of loan transactions. TherAe ips naognotes pPayDabFle mEastnerhfialenorcinederpendent verification of ending balances; however, the notes payable records are maintained by a secretary who does not have access to cash.

The audit has been done by the same CPA firm for several years. In the current year, the following procedures were performed to verify notes payable:

1. Obtain a list of notes payable from the client, foot the notes payable balances on the list, and trace the total to the general ledger.

2. Examine duplicate copies of notes for all outstanding notes included on the listing. Compare the name of the lender, amount, and due date on the duplicate copy with the list.

3. Obtain a confirmation from lenders for all listed notes payable. The confirmation should include the due date of the loan, the amount, and interest payable at the balance sheet date.

4. Recompute accrued interest on the list for all notes. The information for determining the correct accrued interest is to be obtained from the duplicate copy of the note. Foot the accrued interest amounts and trace the balance to the general ledger.

a. What should be the emphasis in the verification of notes payable in this situation? Explain.

b. State the purpose of each of the four audit procedures listed.

c. Evaluate whether each of the four audit procedures was necessary. Evaluate the sample size for each procedure.

d. List other audit procedures that should be performed in the audit of notes payable in these circumstances.

22-26 (Objective 22-2) The following covenants are extracted from the indenture of a bond issue. The indenture provides that failure to comply with its terms in any respect auto- matically makes the loan immediately due (the regular date is 20 years hence). List any audit

Required

Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 727

728

Required

steps or reporting requirements you think should be taken or recognized in connection with each one of the following:

a. The debtor company shall endeavor to maintain a working capital ratio of 2 to 1 at all times, and in any fiscal year following a failure to maintain said ratio, the company shall restrict compensation of officers to $100,000 per individual. Officers for this purpose shall include chairman of the board of directors, president, all vice presidents, secretary, and treasurer.

b. The debtor company shall keep all property that is security for this debt insured against loss by fire to the extent of 100% of its actual value. Policies of insurance comprising this protection shall be filed with the trustee.

c. The debtor company shall pay all taxes legally assessed against property that is security for this debt within the time provided by law for payment without penalty and shall deposit receipted tax bills or equally acceptable evidence of payment of same with the trustee.

d. A sinking fund shall be deposited with the trustee by semiannual payments of $300,000, from which the trustee shall, in his discretion, purchase bonds of this issue.*

22-27 (Objective 22-2) The Redford Corporation took out a 20-year mortgage on June 15, 2011, for $2,600,000 and pledged its only manufacturing building and the land on which the building stands as collateral. Each month subsequent to the issue of the mortgage, a payment of $20,000 was paid to the mortgagor. You are in charge of the current year audit for Redford, which has a balance sheet date of December 31, 2011. The client has been audited previously by your CPA firm, but this is the first time Redford Corporation has had a mortgage.

a. Explain why it is desirable to prepare an audit schedule for the permanent file for the mortgage. What type of information should be included in the schedule?

Required

d. Identify the types of information that should be disclosed in the footnotes for this long-term note payable to help the auditor determine whether the completeness presentation and disclosure audit objective is satisfied.

22-28 (Objectives 22-3, 22-4) Items 1 through 6 are common questions found in internal control questionnaires used by auditors to obtain an understanding of internal control for owners’ equity. In using the questionnaire for a client, a “yes” response indicates a possible internal control, whereas a “no” indicates a potential deficiency.

1. Does the company use the services of an independent registrar or transfer agent?

2. If an independent registrar and transfer agent are not used:

(a) Areunissuedcertificatesproperlycontrolled?

(b) Are cancelled certificates mutilated to prevent their reuse?

3. Are common stock master files and stock certificate books periodically reconciled

with the general ledger by an independent person?

4. Is an independent transfer agent used for disbursing dividends? If not, is an imprest

dividend account maintained?

5. Are issues and retirements of stock authorized by the board of directors?

6. Are all entries in the owners’ equity accounts authorized at the proper level in the

organization?

a. For each of the preceding questions, state the purpose of the control.

b. For each of the preceding questions, identify the type of potential financial statement misstatements if the control is not in effect.

*AICPA adapted.

b. Explain why the audit of mortgage payable, interest expense, and interest payable should all be done together.

c. List the audit procedures that should ordinarily be performed to verify the issue of the mortgage, the balance in the mortgage and interest payable accounts at December 31, 2011, and the balance in interest expense for the year 2011.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

c. For each of the potential misstatements in part b, list an audit procedure that the auditor can use to determine whether a material misstatement exists.

22-29 (Objectives 22-3, 22-4) The following audit procedures are commonly performed by auditors in the verification of owners’ equity:

1. Review the articles of incorporation and bylaws for provisions about owners’ equity. 2. Analyze all owners’ equity accounts for the year and document the nature of any

recorded change in each account.

3. Account for all certificate numbers in the capital stock book for all shares outstanding. 4. Examine the stock certificate book for any stock that was cancelled.

5. Review the minutes of the board of directors’ meetings for the year for approvals

related to owners’ equity.

6. Recompute earnings per share.

7. Review debt provisions and senior securities with respect to liquidation preferences,

dividends in arrears, and restrictions on the payment of dividends or the issue of stock.

a. State the purpose of each of these seven audit procedures.

b. List the type of misstatements the auditors can uncover by the use of each audit procedure.

22-30 (Objectives 22-3, 22-4) You are engaged in the audit of a corporation whose records have not previously been audited by you. The corporation has both an independent transfer agent and a registrar for its capital stock. The transfer agent maintains the record of stockholders and the registrar checks that there is no overissue of stock. Signatures of both are required to validate certificates.

It has been proposed that confirmations be obtained from both the transfer agent and the registrar as to the stock outstanding at the balance sheet date. If such confirmations agree with the books, no additional work is to be performed as to capital stock.

Required

If you agree that obtaining the confirmations as suggested will be sufficient in this case, give

Required

the justification for your position. If you do not agree, state specifically all additional steps you would take and explain your reasons for taking them.*

22-31 (Objective 22-4) You are a CPA engaged in an audit of the financial statements of Pate Corporation for the year ended December 31, 2011. The financial statements and records of Pate Corporation have not been audited by a CPA in prior years.

The stockholders’ equity section of Pate Corporation’s balance sheet at December 31, 2011, follows:

Stockholders’ Equity

Capital stock 10,000 shares of $10 par value authorized; 5,000 shares issued and outstanding

Capital contributed in excess of par value of capital stock Retained earnings

Total stockholders’ equity

$ 50,000

32,580

47,320 ________

$129,900

Pate Corporation was founded in 2004. The corporation has 10 stockholders and serves as its own registrar and transfer agent. There are no capital stock subscription contracts in effect.

a. Prepare the detailed audit program for the audit of the three accounts comprising the stockholders’ equity section of Pate Corporation’s balance sheet. (Do not include in the audit program the verification of the results of the current year’s operations.)

b. After every other figure on the balance sheet has been audited, it might appear that the retained earnings figure is a balancing figure and requires no further verification. Why does the CPA verify retained earnings as is done with the other figures on the balance sheet? Discuss.*

Required

*AICPA adapted.

Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 729

 

730

Required

22-32 (Objective 22-3) E-Antiques, Inc. is an Internet-based market maker for buyers and sellers of antique furniture and jewelry. The company allows sellers of antique items to list descriptions of those items on the E-Antiques Web site. Interested buyers review the Web site for antique items and then enter into negotiations directly with the seller for purchase. E-Antiques receives a commission on each transaction.

The company, founded in 2007, initially obtained capital through equity funding provided by the founders and through loan proceeds from financial institutions. In early 2010, E-Antiques became a publicly held company when it began selling shares on a national stock exchange. Although the company had never generated profits, the stock offering generated large proceeds based on favorable expectations for the company, and the stock quickly increased to above $100 per share.

Management used the proceeds to pay off loans to financial institutions and to reacquire shares issued to the company founders. Proceeds were also used to fund purchases of hardware and software used to support the online market. The balance of unused proceeds is currently held in the company’s bank accounts.

a. Before performing analytical procedures related to the capital acquisition and repayment cycle accounts, consider how the process of becoming publicly held will affect accounts at E-Antiques, Inc. Describe whether each of the following balances would have increased, decreased, or experienced no change between 2009 and 2010 because of the public offering:

(1) Cash

(2) Accounts receivable

(3) Property,plant,andequipment (4) Accounts payable

(5) Long-term debt

(6) Common stock

(7) Additional paid-in capital (8) Retained earnings

(9) Treasurystock

(10) Dividends (11) Revenues

b. During 2011, the stock price for E-Antiques plummeted to around $19 per share. No new shares were issued during 2011. Describe the impact of this drop in stock price on thAe fpollaowginog accPouDntsFfor tEhenyeharaenndecd Decrember 31, 2011:

(1) Common stock

(2) Additional paid-in capital (3) Retained earnings

c. How does the decline in stock price affect your assessment of client business risk and acceptable audit risk?

INTERNET PROBLEM 22-1: OVERVIEW OF THE NYSE

Required

Many companies aspire to go public and have their shares traded on exchanges such as the New York Stock Exchange (NYSE) and NASDAQ. Visit the Website of the NYSE (www.nyse.com) and search for the “Guide to the NYSE Marketplace” to answer the following questions.

a. What two U.S. securities exchanges does the NYSE Group Inc. operate? Briefly describe each.

b. What is required to be able to trade securities on the NYSE trading floor?

c. How many shares does the NYSE have the capacity to trade in a single trading day?

d. How do most trade orders reach the NYSE trading floor?

e. What federal agency oversees the NYSE and its member organizations?

f . Describe the three widely cited stock market indexes described in the NYSE materials. g. Describe the five basic categories of stock.

Chapter 23

REVIEW QUESTIONS

23-1 (Objectives 23-1, 23-2) Explain the relationships among the initial assessed control risk, tests of controls and substantive tests of transactions for cash receipts, and the tests of details of cash balances.

23-2 (Objectives 23-1, 23-2) Explain the relationships among the initial assessed control risk, tests of controls and substantive tests of transactions for cash disbursements, and the tests of details of cash balances. Give one example in which the conclusions reached about internal controls in cash disbursements will affect the tests of cash balances.

23-3 (Objective 23-3) Why is the monthly reconciliation of bank accounts by an inde- pendent person an important internal control over cash balances? Which individuals will generally not be considered independent for this responsibility?

23-4 (Objective 23-3) Evaluate the effectiveness and state the shortcomings of the prepara- tion of a bank reconciliation by the controller in the manner described in the following statement: “When I reconcile the bank account, the first thing I do is review the sorted list of returned checks and find which numbers are missing. Next I determine the amount of the uncleared checks by referring to the cash disbursements journal. If the bank account reconciles at that point, I am all finished with the reconciliation. If it does not, I search for deposits in transit, checks from the beginning outstanding check list that still have not cleared, other reconciling items, and bank errors until it reconciles. In most instances, I can do the reconciliation in 20 minutes.”

23-5 (Objective 23-3) How do bank confirmations differ from positive confirmations of accounts receivable? Distinguish between them in terms of the nature of the information confirmed, the sample size, and the appropriate action when the confirmation is not

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

returned after the second request. Explain the rationale for the differences between these two types of confirmations.

23-6 (Objective 23-3) Evaluate the necessity of following the practice described by an auditor: “In confirming bank accounts, I insist upon a response from every bank the client has done business with in the past 2 years, even though the account may be closed at the balance sheet date.”

23-7 (Objective 23-3) Describe what is meant by a cutoff bank statement and state its purpose.

23-8 (Objective 23-3) Why are auditors usually less concerned about the client’s cash receipts cutoff than the cutoff for sales? Explain the procedure involved in testing for the cutoff for cash receipts.

23-9 (Objective 23-2) What is meant by an imprest bank account for a branch operation? Explain the purpose of using this type of bank account.

23-10 (Objective 23-4) Explain the purpose of a four-column proof of cash. List two types of misstatements it is meant to uncover.

23-11 (Objective 23-3) When the auditor fails to obtain a cutoff bank statement, it is common to verify the entire statement for the month subsequent to the balance sheet date. How is this done and what is its purpose?

23-12 (Objective 23-4) Distinguish between lapping and kiting. Describe audit procedures that can be used to uncover each.

23-13 (Objective 23-5) Assume that a client with excellent internal controls uses an imprest payroll bank account. Explain why the verification of the payroll bank recon- ciliation ordinarily takes less time than the tests of the general bank account, even if the number of disbursements exceeds those for the general account.

important?

23-15 (Objectives 23-3, 23-4) Why is there a greater emphasis on the detection of fraud in tests of details of cash balances than for other balance sheet accounts? Give two specific examples that demonstrate how this emphasis affects the auditor’s evidence accumulation in auditing year-end cash.

23-16 (Objective 23-3) Explain why, in verifying bank reconciliations, most auditors emphasize the possibility of a nonexistent deposit in transit being included in the recon- ciliation and an outstanding check being omitted rather than the omission of a deposit in transit and the inclusion of a nonexistent outstanding check.

23-17 (Objective 23-3) How will a company’s bank reconciliation reflect an electronic deposit of cash received by the bank from credit card agencies making payments on behalf of customers purchasing products from the company’s online Web site, but not recorded in the company’s records?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

23-18 (Objectives 23-3, 23-4) The following questions deal with auditing year-end cash. Choose the best response.

a. A CPA obtains a January 10 cutoff bank statement for a client directly from the bank. Very few of the outstanding checks listed on the client’s December 31 bank recon- ciliation cleared during the cutoff period. A probable cause for this is that the client (1) is engaged in kiting.

(2) is engaged in lapping.

(3) transmitted the checks to the payees after year-end. (4) has overstated its year-end bank balance.

23-14 (Objective 23-6) Distinguish between the verification of petty cash reimbursements and the verification of the balance in the fund. Explain how each is done. Which is more

Chapter 23 / AUDIT OF CASH BALANCES 749

750

b. The auditor should ordinarily send confirmation requests to all banks with which the client has conducted any business during the year, regardless of the year-end balance, because

(1) this procedure will detect kiting activities that would otherwise not be detected.

(2) the confirmation form also seeks information about indebtedness to the bank.

(3) the sending of confirmation requests to all such banks is required by auditing

standards.

(4) this procedure relieves the auditor of any responsibility with respect to non-

detection of forged checks.

c. The usefulness of the standard bank confirmation request may be limited because the bank employee who completes the confirmation may

(1) be unaware of all the financial relationships that the bank has with the client.

(2) notbelievethebankisobligatedtoverifyconfidentialinformationtoathirdparty.

(3) sign and return the confirmation without inspecting the accuracy of the client’s

bank reconciliation.

(4) not have access to the client’s bank statement.

23-19 (Objective 23-4) The following questions deal with discovering fraud in auditing year-end cash. Choose the best response.

a. Which of the following is one of the better auditing techniques to detect kiting?

(1) Review composition of authenticated deposit slips.

(2) Review subsequent bank statements and cancelled checks received directly from

the banks.

(3) Prepare year-end bank reconciliations.

(4) Prepare a schedule of bank transfers from the client’s books.

b. Which of the following cash transfers results in a misstatement of cash at December 31, 2011?

Disbursements

Recorded

Transfer in books

(1) 12/31/11 (2) 1/4/12 (3) 12/31/11 (4) 1/4/12

Paid by Recorded

bank in books

1/4/12 12/31/11 1/5/12 12/31/11 1/5/12 12/31/11

1/11/12 1/4/12

Receipt

Received

by bank

12/31/11 1/4/12 1/4/12 1/4/12

BANK TRANSFER SCHEDULE

c. A cash shortage may be concealed by transporting funds from one location to another or by converting negotiable assets to cash. Because of this, which of the following is vital? (1) Simultaneous bank confirmations.

(2) Simultaneous bank reconciliations.

(3) Simultaneous four-column proofs of cash. (4) Simultaneous surprise cash counts.

DISCUSSION QUESTIONS AND PROBLEMS

23-20 (Objectives 23-3, 23-4) The following are misstatements that might be found in the client’s year-end cash balance (assume that the balance sheet date is June 30):

1. The outstanding checks on the June 30 bank reconciliation were underfooted by $2,000.

2. A loan from the bank on June 26 was credited directly to the client’s bank account. The loan was not entered as of June 30.

3. A check was omitted from the outstanding check list on the June 30 bank recon- ciliation. It cleared the bank July 7.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

4. A check was omitted from the outstanding check list on the bank reconciliation. It cleared the bank September 6.

5. Cash receipts collected on accounts receivable from July 1 to July 5 were included as June 29 and 30 cash receipts.

6. A bank transfer recorded in the accounting records on July 1 was included as a deposit in transit on June 30.

7. A check that was dated June 26 and disbursed in June was not recorded in the cash disbursements journal, but it was included as an outstanding check on June 30.

a. Assuming that each of these misstatements was intentional (fraud), state the most likely motivation of the person responsible.

b. What control can be instituted for each fraud to reduce the likelihood of occurrence? c. List an audit procedure that can be used to discover each fraud.

23-21 (Objectives 23-3, 23-4) The following audit procedures are concerned with tests of details of general cash balances:

1. Obtain a standard bank confirmation from each bank with which the client does business.

2. Compare the balance on the bank reconciliation obtained from the client with the bank confirmation.

3. Compare the checks returned along with the cutoff bank statement with the list of outstanding checks on the bank reconciliation.

4. List the check number, payee, and amount of all material checks not returned with the cutoff bank statement.

5. Review minutes of the board of directors meetings, loan agreements, and bank confirmation for interest-bearing deposits, restrictions on the withdrawal of cash, and compensating balance agreements.

Required

6. Prepare a four-column proof of cash.

7. Compare the bank cancellation date with the date on the cancelled check for checks

Beginning balance 7/1/11 Deposits

Cash receipts journal Checks cleared

Cash disbursements journal July bank service charge Note paid directly

NSF check

Ending balance 7/31/11

$

6,400 26,874 (23,171)

$

8,378 25,474

(25,307)

(107) (6,400) (516)

dated on or shortly before the balance sheet date.

8. Trace deposits in transit on the bank reconciliation to the cutoff bank statement and

the current year cash receipts journal. Explain the objective of each.

23-22 (Objective 23-3) You are auditing general cash for the Pittsburgh Supply Company for the fiscal year ended July 31, 2011. The client has not prepared the July 31 bank reconciliation. After a brief discussion with the owner, you agree to prepare the recon- ciliation, with assistance from one of Pittsburgh Supply’s clerks. You obtain the following information:

Required

General Ledger

Bank Statement

________ $ 10,103

________ $ 1,522

June 30 Bank Reconciliation

Information in General Ledger and Bank Statement

Balance per bank Deposits in transit Outstanding checks Balance per books

$8,378 600 2,578 6,400

Chapter 23 / AUDIT OF CASH BALANCES 751

752

Required

Additional information obtained is as follows:

1. Checks clearing that were outstanding on June 30 totaled $2,411.

2. Checks clearing that were recorded in the July disbursements journal totaled $21,120.

3. A check for $1,130 cleared the bank but had not been recorded in the cash disburse-

ments journal. It was for an acquisition of inventory. Pittsburgh Supply uses the

periodic-inventory method.

4. A check for $646 was charged to Pittsburgh Supply but had been written on a

different company’s bank account.

5. Deposits included $600 from June and $24,874 for July.

6. The bank charged Pittsburgh Supply’s account for a nonsufficient check totaling

$516. The credit manager concluded that the customer intentionally closed its account and the owner left the city. The check was turned over to a collection agency.

7. A note for $6,000, plus interest, was paid directly to the bank under an agreement signed 4 months ago. The note payable was recorded at $6,000 on Pittsburgh Supply’s books.

a. Prepare a bank reconciliation that shows both the unadjusted and adjusted balance per books.

b. Prepare all adjusting entries.

c. What audit procedures would you use to verify each item in the bank reconciliation?

d. What is the cash balance that should appear on the July 31, 2011, financial statements?

23-23 (Objectives 23-3, 23-4) In the audit of the Regional Transport Company, a large branch that maintains its own bank account, cash is periodically transferred to the central account in Cedar Rapids. On the branch account’s records, bank transfers are recorded as a debit to the home office clearing account and a credit to the branch bank account. Similarly, the home office account is recorded as a debit to the central bank account and a

credit to the branch office clearing account. Gordon Light is the head bookkeeper for both the home office and the branch bank accounts. Because he also reconciles the bank account, the senior auditor, Cindy Marintette, is concerned about the internal control deficiency.

As a part of the year-end audit of bank transfers, Marintette asks you to schedule the trans- fers for the last few days in 2011 and the first few days of 2012. You prepare the following list:

Amount of

Transfer

$17,000 28,000 16,000 10,000 21,000 22,000 39,000

Date Recorded in the Home Office Cash Receipts Journal

12-27-11 12-28-11 01-02-12 12-26-11 01-02-12 01-07-12 01-04-12

Date Recorded in

the Branch Office Cash Disbursements Journal

12-29-11 01-02-12 12-30-11 12-26-11 01-02-12 01-05-12 01-06-12

Date Deposited in the Home Office Bank Account

12-26-11 12-28-11 12-28-11 12-28-11 12-28-11 12-28-11 01-03-12

Date Cleared the Branch Bank Account

12-27-11 12-29-11 12-29-11 01-03-12 12-31-11 01-03-12 01-05-12

Required

a. In verifying each bank transfer, state the appropriate audit procedures you should perform.

b. Prepare any adjusting entries required in the home office records. c. Prepare any adjusting entries required in the branch bank records.

d. State how each bank transfer should be included in the December 31, 2011, bank reconciliation for the home office account after your adjustments in part b.

e. State how each bank transfer should be included in the December 31, 2011, bank reconciliation of the branch bank account after your adjustments in part c.

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

23-24 (Objective 23-4) The following are various potential misstatements due to errors or fraud (1 through 7), and a list of auditing procedures (a through h) the auditor would consider performing to gather evidence to determine whether the error or fraud is present.

Possible Misstatements Due to Errors or Fraud

1. The auditor suspects that a lapping scheme exists because an accounting department employee who has access to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days.

2. The auditor suspects that the entity is inappropriately increasing the cash reported on its balance sheet by drawing a check on one account and not recording it as an outstanding check on that account and simultaneously recording it as a deposit in a second account.

3. The entity’s cash receipts of the first few days of the subsequent year were properly deposited in its general operating account after the year-end. However, the auditor suspects that the entity recorded the cash receipts in its books during the last week of the year under audit.

4. The auditor noticed a significant increase in the number of times that petty cash was reimbursed during the year and suspects that the custodian is stealing from the petty cash fund.

5. The auditor suspects that a kiting scheme exists because an accounting department employee who can issue and record checks seems to be leading an unusually luxurious lifestyle.

6. During tests of the reconciliation of the payroll bank account, the auditor notices that a check to an employee is significantly larger than other payroll checks.

7. The auditor suspects that the controller wrote several checks and recorded the cash disbursements just before year-end but did not mail the checks until after the first week of the subsequent year.

List of Auditing Procedures

a. b.

c. d. e.

f .

g. h.

Send a standard bank confirmation confirming the balance in the bank at year-end. Compare the details of the cash receipts journal entries with the details of the

corresponding daily deposit slips.

Count the balance in petty cash at year-end.

Agree gross amount on payroll checks to approved hours and pay rates.

Obtain the cutoff bank statement and compare the cleared checks to the year-end reconciliation.

Examine invoices, receipts, and other documentation supporting reimbursement of petty cash.

Examine payroll checks clearing after year-end with the payroll journal.

Prepare a bank transfer schedule.

For each possible misstatement, identify one audit procedure that would be most effective in providing evidence regarding the potential misstatement. Listed auditing procedures may be used once, more than once, or not at all.*

23-25 (Objective 23-3) In connection with an audit you are given the following worksheet: Bank Reconciliation, December 31, 2011

Required

Balance per ledger December 31, 2011

Add:

Cash receipts received on the last day of December and charged to “cash in bank” on books but not deposited

Debit memo for customer’s check returned unpaid (check is on hand but no entry has been made on the books)

Debit memo for bank service charge for December

$27,253.85

3,715.27

450.00

35.00 _________

$31,454.12

(continued on following page)

*AICPA adapted.

Chapter 23 / AUDIT OF CASH BALANCES 753

754

Required

a. Prepare a corrected reconciliation.

b. Prepare journal entries for items that should be adjusted prior to closing the books.*

Required

6. Interest on a bank loan for the month of October, charged by the bank but not recorded, was $596.

7. Proceeds on a note of the Jones Company were collected by the bank on October 28 but were not entered on the books:

Principal $ 2,900

Interest 396 _______

$ 3,296

8. On October 26, a $1,144 check of the Billings Company was charged to Sherman School District’s account by the bank in error.

9. Dishonored checks are not recorded on the books unless they permanently fail to clear the bank. The bank treats them as disbursements when they are dishonored and deposits when they are redeposited. Checks totaling $1,335 were dishonored in October; $600 was redeposited in October and $735 in November.

a. Prepare a four-column proof of cash for the month ended October 31. It should show both adjusted and unadjusted cash.

b. Prepare all adjusting entries. *AICPA adapted.

Deduct:

Checks drawn but not paid by bank (see detailed list below) Credit memo for proceeds of a note receivable that had been left at the bank for collection but which has not

been recorded as collected

Checks for an account payable entered on books as

$297.50 but drawn and paid by bank as $694.50

Computed balance Unlocated difference

Balance per bank (checked to confirmation)

Checks Drawn but Not Paid by Bank

$3,295.15

1,200.00

397.00 ________

(4,892.15) _________

26,561.97

416.44 _________

$26,978.41

No.

573 724 903 907 911 913 914 916 917

Amount

$ 267.27

39.92

454.67

291.80

648.29

737.52

529.10

36.00

117.26 __________

$ 3,295.15

23-26 (Objective 23-4) You are doing the first-year audit of Sherman School District and have been assigned responsibility for doing a four-column proof of cash for the month of October 2011. You obtain the following information:

per books September 30 October 31

1. Balance per books

2. Balance per bank

3. Outstanding checks

4. Cash receipts for October

5. Deposits in transit

September 30 October 31 September 30 October 31 September 30 October 31 per bank

$ 10,725 5,836 6,915 8,276 1,811 2,615 28,792 20,271 5,621 996

Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

 

INTERNET PROBLEM 23-1: CHECK CLEARING FOR THE 21ST CENTURY ACT

The Check Clearing for the 21st Century Act (Check 21 Act) allows recipients of paper checks to create a digital image of the original check, eliminating the need for further handling of the actual check. The Federal Reserve Board has created a consumer guide (www.federalreserve.gov/pubs/check21/consumer_guide.htm). Locate the guide to answer questions about Check 21.

a. What is a “substitute check”? Does it constitute a legal copy of the check? b. How does Check 21 affect the payment of your checks?

c. Do banks have to return actual cancelled checks? Explain.

Chapter 24

REVIEW QUESTIONS

Subsequent discovery of facts—auditor discovery that the financial statements are materially misstated after they have been issued

Subsequent events—transactions and other pertinent events that occurred after the balance sheet date that affect the fair presentation or disclosure of the state- ments being audited

Unadjusted misstatement audit schedule— a summary of immaterial misstatements not adjusted at the time they were found, used to help the auditor assess whether the combined amount is material; also known as a summary of possible misstatements

Unasserted claim—a potential legal claim against a client where the condition for a claim exists but no claim has been filed

Part 5 / COMPLETING THE AUDIT

24-1 (Objective 24-1) Identify and describe the four presentation and disclosure audit objectives.

24-2 (Objective 24-1) Describe the purpose of a financial statement disclosure checklist

and explain how it helps the auditor determine if there is sufficient appropriate evidence

for each of the presentation and disclosure objectives.

24-3 (Objective 24-2) Distinguish between a contingent liability and an actual liability and give three examples of each.

24-4 (Objective 24-2) 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.

24-5 (Objective 24-2) Explain why an auditor is interested in a client’s future commitments to purchase raw materials at a fixed price.

24-6 (Objective 24-3) Explain why the analysis of legal expense is an essential part of every audit.

24-7 (Objectives 24-2, 24-3) During the audit of the Merrill Manufacturing Company, Ralph Pyson, CPA, has become aware of four lawsuits against the client through 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?

24-8 (Objective 24-3) Distinguish between an asserted and an unasserted claim. Explain why a client’s attorney may not reveal an unasserted claim.

24-9 (Objective 24-3) 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.

24-10 (Objective 24-4) Distinguish between the two general types of subsequent events and explain how they differ. Give two examples of each type.

24-11 (Objectives 24-3, 24-4) 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 of unresolved loose ends near the end of the audit. Evaluate Malano’s approach.

24-12 (Objective 24-4) What major considerations should the auditor take into account in determining how extensive the review of subsequent events should be?

24-13 (Objective 24-4) Identify five audit procedures normally done as a part of the review for subsequent events.

24-14 (Objectives 24-4, 24-8) 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.

24-15 (Objective 24-5) Miles Lawson, CPA, believes that the final summarization is the easiest part of the audit if careful planning is followed throughout the audit. He makes sure that each segment of the audit is completed before he goes on to the next. When the last 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.

24-16 (Objectives 24-1, 24-5, 24-6) 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.

24-17 (Objectives 24-5, 24-7) 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.

24-18 (Objective 24-5) 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?

24-19 (Objective 24-5) What is meant by reading other financial information in annual

reports? Give an example of the type of information the auditor is examining.

24-20 (Objective 24-6) 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.

24-21 (Objective 24-7) Describe matters that the auditor must communicate to audit committees of public companies.

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

24-22 (Objective 24-2) The following questions deal with contingent liabilities. Choose the best response.

a. The audit step most likely to reveal the existence of contingent liabilities is (1) a review of vouchers paid during the month following the year-end. (2) an inquiry directed to legal counsel.

(3) accounts payable confirmations.

(4) mortgage-note confirmation.

b. Which of the following would be least likely to be included in a standard inquiry to the client’s attorney?

(1) A list provided by the client of pending litigation or asserted or unasserted claims

with which the attorney has had some involvement.

(2) Arequestfortheattorneytoopineonthecorrectaccountingtreatmentassociated

with an outstanding claim or pending lawsuit outcome.

(3) Arequestthattheattorneyprovideinformationaboutthestatusofpendinglitigation.

(4) A request for the attorney to identify any pending litigation or threatened legal

action not identified on a list provided by the client.

Chapter 24 / COMPLETING THE AUDIT 781

782

Part 5 / COMPLETING THE AUDIT

c. When a contingency is resolved subsequent to the issuance of audited financial state- ments, which correctly contained disclosure of the contingency in the footnotes based on information available at the date of issuance, the auditor should

(1) take no action regarding the event.

(2) insist that the client issue revised financial statements.

(3) inform the audit committee that the report cannot be relied on.

(4) inform the appropriate authorities that the report cannot be relied on.

24-23 (Objectives 24-5, 24-7) The following questions concern communications between management, those charged with governance, and the auditor. Choose the best response.

a. A principal purpose of a letter of representation from management is to

(1) serve as an introduction to company personnel and an authorization to examine

the records.

(2) discharge the auditor from legal liability for the audit.

(3) confirminwritingmanagement’sapprovaloflimitationsonthescopeoftheaudit.

(4) remind management of its primary responsibility for financial statements.

b. The date of the management representation letter should coincide with the

(1) balance sheet date.

(2) date of the auditor’s report.

(3) dateofthelatestsubsequenteventreferredtointhenotestothefinancialstatements. (4) date of the engagement agreement.

c. Which of the following is not a required item to be communicated by the auditor to the audit committee or others charged with governance?

(1) Informationabouttheauditor’sresponsibilityinanauditoffinancialstatements. (2) Information about the overall scope and timing of the audit.

(3) Recommendations for improving the client’s business.

(4) Significant findings arising from the audit.

d. A management letter

(1) is the auditor’s report on significant deficiencies and material weaknesses in

internal control.

(2) contains management’s representations to the auditor documenting statements

made by management to the auditor during the audit about matters affecting the

financial statements.

(3) is mandatory in all audits and must be dated the same date as the audit report.

(4) contains recommendations from the auditor designed to help the client improve

the efficiency and effectiveness of its business.

24-24 (Objective 24-4) The following questions deal with review of subsequent events. Choose the best response.

a. Subsequent events for reporting purposes are defined as events that occur subsequent to the

(1) balance sheet date.

(2) date of the auditor’s report.

(3) balance sheet date but before the date of the auditor’s report.

(4) dateoftheauditor’sreportandconcerncontingenciesthatarenotreflectedinthe

financial statements.

b. An example of an event occurring in the period of the auditor’s field work subsequent

to the end of the year being audited that normally will not require disclosure in the financial statements or auditor’s report is

(1) serious damage to the company’s plant from a widespread flood.

(2) issuance of a widely advertised capital stock issue with restrictive covenants.

(3) settlement of a large liability for considerably less than the amount recorded.

(4) decreased sales volume resulting from a general business recession.

c. Ruffin has audited the financial statements of Weaver Corporation for the year ended December 31, 2011. The auditor completed the audit work on February 22, 2012 and dated the audit report as of that date. The report was delivered to management for inclusion in its financial statements submitted by Weaver Corporation to its banker on February 27,

2012. Ruffin archived all its working papers for the audit on March 1, 2012. Under the circumstances, Ruffin is responsible for reviewing subsequent events occurring through (1) December31,2011. (3) February27,2012.

(2) February22,2012. (4) March1,2012.

24-25 (Objective 24-5) The following questions concern information accompanying basic financial statements. Choose the best response.

a. The Form 10-K filed by management of a public company includes a section on manage- ment’s discussion and analysis (MD&A) in addition to the annual financial statements. Which of the following best describes the auditor’s responsibility for the MD&A information?

(1) The auditor must perform sufficient appropriate audit procedures to opine on the MD&A information.

(2) The auditor has no responsibilities related to the MD&A disclosures.

(3) TheauditormustreadtheMD&Ainformationtodetermineifthereisanymaterial

inconsistency with the audited financial statements.

(4) TheauditormustprovideadisclaimerofopinionrelatedtotheMD&Ainformation.

b. Ansman, CPA, has been requested by a client, Rainco Corp., to prepare information in addition to the basic financial statements for this year’s audit. Which of the following is the best reason for Rainco’s requesting the additional information?

(1) To provide an opinion about the supplemental information when certain items

are not in accordance with accounting standards.

(2) To provide Rainco’s creditors a greater degree of assurance as to the financial

soundness of the company.

(3) To provide Rainco’s management with information to supplement and analyze

the basic financial statements.

(4) To provide the documentation required by the SEC in anticipation of a public

offering of Rainco’s stock.

c. Management of Thurman Corporation included additional supplementary informa-

tion in documents that include the audited financial statements for the year ended December 31, 2011. Management has asked its audit firm, Wally, CPAs, whether they can report on the supplementary information. Which of the following conditions would preclude Wally, CPAs from conducting this engagement?

(1) The supplementary information is derived from the accounting records used to generate the basic financial statements.

(2) The supplementary information covers the period January 1, 2011 through February 15, 2012.

(3) Wally’s opinion of the basic financial statements was unqualified.

(4) When evaluating supplementary information, Wally plans to use the same

materiality threshold as that used in the audit of the basic financial statements.

DISCUSSION QUESTIONS AND PROBLEMS

24-26 (Objective 24-1, 24-2) Elizabeth Johnson, CPA, has completed the audit of notes payable and other liabilities for Valley River Electrical Services and now plans to audit con- tingent liabilities and commitments.

a. Distinguish between contingent liabilities and commitments and explain why both Required are important in an audit.

b. Describe how Johnson’s testing in phases I-III of the audit of notes payable might help her obtain evidence about the four presentation and disclosure objectives.

c. Identify three useful audit procedures for uncovering contingent liabilities that Johnson will likely perform in the normal conduct of the audit, even if she had no responsibility for uncovering contingencies.

d. Identify three other procedures Johnson is likely to perform specifically for the pur- pose of identifying undisclosed contingencies.

Chapter 24 / COMPLETING THE AUDIT 783

784

Required

24-27 (Objective 24-2) In an audit of the Marco Corporation as of December 31, 2011, the following situations exist. No entries have been made in the accounting records in relation to these items.

1. During the year 2011, the Marco Corporation was named as a defendant in a suit for damages by the Dalton Company for breach of contract. An adverse decision to the Marco Corporation was rendered and the Dalton Company was awarded $4,000,000 damages. At the time of the audit, the case was under appeal to a higher court.

2. On December 23, 2011, the Marco Corporation declared a common stock dividend of 1,000 shares with a par value of $1,000,000 of its common stock, payable February 2, 2012, to the common stockholders of record December 30, 2011.

3. The Marco Corporation has guaranteed the payment of interest on the 10-year, first mortgage bonds of the Newart Company, an affiliate. Outstanding bonds of the Newart Company amount to $5,500,000 with interest payable at 5% per annum, due June 1 and December 1 of each year. The bonds were issued by the Newart Company on December 1, 2009, and all interest payments have been met by that company with the exception of the payment due December 1, 2011. The Marco Corporation states that it will pay the defaulted interest to the bondholders on January 15, 2012.

a. Define contingent liability.

b. Describe the audit procedures you would use to learn about each of the situations listed. c. Describe the nature of the adjusting entries or disclosure, if any, you would make for

each of these situations.*

24-28 (Objective 24-3) In analyzing legal expense for the Boastman Bottle Company, Mary Little, CPA, observes that the company has paid legal fees to three different law firms during the current year. In accordance with her CPA firm’s normal operating practice, Little requests standard attorney letters as of the balance sheet date from each of the three law firms.

On the last day of field work, Little notes that one of the attorney letters has not yet been

received. The second letter contains a statement to the effect that the law firm deals

Required

Required

a. Evaluate Little’s approach to sending the attorney letters and her follow-up on the responses. b. What should Little do about each of the letters?

24-29 (Objective 24-4) The following unrelated events occurred after the balance sheet date but before the audit report was prepared:

1. The granting of a retroactive pay increase

2. Declaration of a stock dividend

3. Sale of a fixed asset at a substantial profit

4. Determination by the federal government of additional income tax due for a prior year 5. Filing of an antitrust suit by the federal government

a. Explain how each of the items might have come to the auditor’s attention.

b. Discuss the auditor’s responsibility to recognize each of these in connection with the report.*

24-30 (Objectives 24-4, 24-8) The field work for the June 30, 2011, audit of Tracy Brewing Company was finished August 19, 2011, and the completed financial statements, accom- panied by the signed audit reports, were mailed September 6, 2011. In each of the highly material independent events (a through i), state the appropriate action (1 through 4) for the situation and justify your response. The alternative actions are as follows:

1. Adjust the June 30, 2011, financial statements.

2. Disclose the information in a footnote in the June 30, 2011, financial statements. 3. Request the client to recall the June 30, 2011, statements for revision.

4. No action is required.

*AICPA adapted.

Part 5 / COMPLETING THE AUDIT

exclusively in registering patents and refuses to comment on any lawsuits or other legal

affairs of the client. The third attorney’s letter states that there is an outstanding unpaid bill due from the client and recognizes the existence of a potentially material lawsuit against the client but refuses to comment further to protect the legal rights of the client.

The events are as follows:

a.

b.

c.

d.

e.

f . g.

h. i .

On December 14, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on July 15, 2011, due to declining financial health. The sale had taken place January 15, 2011.

On December 14, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on October 2, 2011. The sale had taken place April 15, 2011, but the amount appeared collectible at June 30, 2011, and August 19, 2011.

On August 15, 2011, the auditor discovered that a debtor of Tracy Brewing went bankrupt on August 1, 2011. The most recent sale had taken place April 2, 2010, and no cash receipts had been received since that date.

On August 6, 2011, the auditor discovered that a debtor of Tracy Brewing went bank- rupt on July 30, 2011. The cause of the bankruptcy was an unexpected loss of a major lawsuit on July 15, 2011, resulting from a product deficiency suit by a different customer. On August 6, 2011, the auditor discovered that a debtor of Tracy Brewing went bank- rupt on July 30, 2011, for a sale that took place July 3, 2011. The cause of the bankruptcy was a major uninsured fire on July 20, 2011.

On July 20, 2011, Tracy Brewing settled a lawsuit out of court that had originated in 2008 and is currently listed as a contingent liability.

On September 14, 2011, Tracy Brewing lost a court case that had originated in 2010 for an amount equal to the lawsuit. The June 30, 2011, footnotes state that in the opinion of legal counsel there will be a favorable settlement.

On July 20, 2011, a lawsuit was filed against Tracy Brewing for a patent infringement action that allegedly took place in early 2011. In the opinion of legal counsel, there is a danger of a significant loss to the client.

On May 31, 2011, the auditor discovered an uninsured lawsuit against Tracy Brewing that had originated on February 28, 2011.

24-31 (Objective 24-5) Leslie Morgan, CPA, has prepared a letter of representation for the

president and controller to sign. It contains references to the following items:

1. Inventory is fairly stated at the lower of cost or market and includes no obsolete items. 2. All actual and contingent liabilities are properly included in the financial statements. 3. All subsequent events of relevance to the financial statements have been disclosed.

a. Why is it desirable to have a letter of representation from the client concerning these Required matters when the evidence accumulated during the course of the audit is meant to verify

the same information?

b. To what extent is the letter of representation useful as audit evidence? Explain.

c. List several other types of information commonly included in a letter of representation.

24-32 (Objective 24-5) As a part of the audit of Ren Gold Manufacturing Company, a non- public company, management requests basic financial statements and separately, the same basic financial statements accompanied by additional information. Management informs you that the intent is to use the basic financial statements for bankers, other creditors, and the two owners who are not involved in management. The basic financial statements accompanied by the additional information are to be used only by management. Manage- ment requests the inclusion of specific information but asks that no audit work be done beyond what is needed for the basic financial statements. The following is requested:

1. A schedule of insurance in force.

2. The auditor’s feelings about the adequacy of the insurance coverage.

3. An aged trial balance of accounts receivable and evaluation of the adequacy of the

allowance for uncollectible accounts.

4. A summary of fixed asset additions.

5. Material weaknesses in internal control and recommendations to improve internal

control.

6. A 5-year summary of the most important company ratios, with the appropriate ratios

to be determined at the auditor’s discretion.

Chapter 24 / COMPLETING THE AUDIT 785

786

Required

7. A schedule of notes payable accompanied by interest rates, collateral, and a payment schedule.

a. What is the difference between basic financial statements and additional information? b. What are the purposes of additional information accompanying basic financial statements? c. For the previously listed items (1 through 7), state which ones could appropriately be

included as additional information. Give reasons for your answer.

d. Identify three other items that may appropriately be included as additional information. e. Assume that an unqualified opinion is proper for the basic financial statements report,

that no testing was done beyond that required for the basic financial statements report, and that only appropriate information is included in the additional informa- tion. Write the proper auditor’s report.

24-33 (Objective 24-6) The following items were discovered during the December 31, 2011 audit of the financial statements of Westmoreland Corporation:

1. The company’s financial statements did not include an accrual for bonuses earned by senior management in 2011 but payable in March 2012. The aggregate bonus amount was $125,000.

2. Equipment originally costing $725,000 that was fully depreciated with a remaining residual value of $60,000 was sold for $85,000 on December 29, 2011. The purchaser agreed to pay for the equipment by January 15, 2012.

3. Based on close examination of the client’s aged accounts receivable trial balance and correspondence files with customers, the auditor determined that management’s allowance for bad debts is overstated by $44,000.

4. Expenses totaling $52,000 associated with the maintenance of equipment were inappropriately debited to the equipment account.

5. Marketing expenses of $43,000 were incorrectly classified as cost of goods sold.

6. The company received new computer equipment on January 3, 2012 that was ordered

and shipped F.O.B. shipping point to Westmoreland on December 27, 2011. No

Required

payable due in full June 30, 2013.

a. Prepare an Unadjusted Misstatement Audit Schedule using the following format (see

Figure 24-6 on page 773 as an example):

Possible Misstatement – Overstatement (Understatement)

Total Current Noncurrent Current Noncurrent Income Amount Assets Assets Liabilities Liabilities Before Tax

b. Balance sheet and income statement materiality for the audit of Westmoreland financial statements is $75,000. What is your conclusion about the financial statements if the audit findings are not corrected by Westmoreland management before you issue the audit report?

24-34 (Objective 24-7) In a letter to the audit committee of the Cline Wholesale Company, Jerry Schwartz, CPA, informed them of material weaknesses in the control of inventory. In a separate letter to senior management, he elaborated on how the material weaknesses could result in a significant misstatement of inventory by the failure to recognize the existence of obsolete items. In addition, Schwartz made specific recommendations in the management letter on how to improve internal control and save clerical time by installing a computer system for the company’s perpetual records. Management accepted the recommendations and installed the system under Schwartz’s direction. For several months, the system worked beautifully, but unforeseen problems developed when a master file was erased. The cost of reproducing and processing the inventory records to correct the error was significant, and management decided to scrap the entire project. The company sued Schwartz for failure to use adequate professional judgment in making the recommendations.

a. What is Schwartz’s legal and professional responsibility in the issuance of manage- ment letters?

b. Discuss the major considerations that will determine whether he is liable in this situation.

entry has been recorded for this purchase that was financed by a long-term note

Required

Part 5 / COMPLETING THE AUDIT

 

24-35 (Objective 24-6) In your audit of Aviary Industries for calendar year 2011, you found a number of matters that you believe represent possible adjustments to the company’s books. These matters are described below. Management’s attitude is that “once the books are closed, they’re closed,” and management does not want to make any adjustments. Planning materiality for the audit was $100,000, determined by computing 5% of expected income before taxes. Actual income before taxes on the financial statements prior to any adjustments is $1,652,867.

Possible adjustments:

1. Several credit memos that were processed and recorded after year-end relate to sales

and accounts receivable for 2011. These total $26,451.

2. Inventory cutoff tests indicate that $25,673 of inventory received on December 30, 2011,

was recorded as purchases and accounts payable in 2012. These items were included in

the inventory count at year-end and therefore were included in ending inventory.

3. Inventory cutoff tests also indicate several sales invoices recorded in 2011 for goods that were shipped in early 2012. The goods were included in inventory even though they were set aside in a separate shipping area. The total amount of these shipments

was $41,814.

4. The company wrote several checks at the end of 2011 for accounts payable that were

held and not mailed until January 15, 2012. These totaled $43,671. Recorded cash and

accounts payable at December 31, 2011, are $2,356,553 and $2,666,290, respectively.

5. The company has not established a reserve for obsolescence of inventories. Your tests indicate that such a reserve is appropriate in an amount somewhere between $15,000

and $30,000.

6. Your review of the allowance for uncollectible accounts indicates that it may be

a.

b. c .

d. e.

understated by between $35,000 and $55,000.

Determine the adjustments that you believe must be made for Aviary’s financial statements

Required

to be fairly presented. Include the amounts and accounts affected by each adjustment. Why may Aviary Industries’ management resist making these adjustments?

Explain what you consider the most positive way of approaching management personnel to convince them to make your proposed changes.

Describe your responsibilities related to unadjusted misstatements that management has determined are immaterial individually and in the aggregate.

Assuming Aviary Industries is an accelerated filer public company, describe how the noted adjustments might impact your audit report on internal control over financial reporting.

CASE

INTERNET PROBLEM 24-1: AUDIT COMMITTEE RESPONSIBILITIES

Audit committees of public companies have many responsibilities in today’s financial reporting environment. Visit the website of Microsoft Corporation (www.microsoft.com) and locate the Audit Committee’s Charter under the “Investor Relations” link to answer the following questions.

a. What is the primary purpose of the Microsoft Audit Committee? Required

b. What responsibility, if any, does the Audit Committee have in regards to the engage-

ment of the external auditor?

c. At a minimum, how often will the Audit Committee meet in a given year?

d. Review the Audit Committee Responsibilities Calendar and briefly describe the nature

of items included in the Audit Committee’s review with Finance management and

the independent auditor upon completion of the audit.

  1. With whom does the Audit Committee meet in executive session? Describe your views about why these sessions are conducted.

Chapter 25

REVIEW QUESTIONS

—an attestation service designed to provide reasonable assurance that a company’s Web site complies with Trust Services principles and criteria for busi- ness-to-consumer electronic commerce

25-1 (Objective 25-1) What is meant by the term level of assurance? How does the level of assurance differ for an audit of historical financial statements, a review, and a compilation?

25-2 (Objective 25-1) What is negative assurance? Why is it used in a review engagement report?

25-3 (Objective 25-1) Distinguish between compilation and review of financial statements. What is the level of assurance for each?

25-4 (Objective 25-1) Distinguish the three forms of compilation reports that a CPA can provide to clients.

25-5 (Objective 25-1) List five things that are required of an auditor by SSARS for a compilation.

25-6 (Objective 25-1) What steps should auditors take if during a compilation engagement they become aware that the financial statements are misleading?

25-7 (Objective 25-1) What procedures should the auditor use to obtain the information necessary to give the level of assurance required of reviews of financial statements?

25-8 (Objective 25-1) What should auditors do if during a review of financial statements they discover that applicable accounting standards are not being followed?

25-9 (Objectives 25-1, 25-2) What are the differences between the review reports for a

private company under SSARS and for the interim financial statements of a public company?

25-10 (Objective 25-2) Explain why a review of interim financial statements for a public company may provide a greater level of assurance than an SSARS review.

25-11 (Objective 25-3) Define what is meant by attestation standards. Distinguish between attestation standards and auditing standards.

25-12 (Objective 25-4) List the five Trust Services principles and explain whether a WebTrust licensed CPA can report on an entity’s compliance with those principles indi- vidually or in combination.

25-13 (Objective 25-4) Describe the purpose of a SysTrust assurance services engagement.

25-14 (Objective 25-5) An audit client has engaged a third party service organization to host its payroll software package on servers located at the service organization. What options do you have to obtain assurance about the controls embedded in the payroll application?

25-15 (Objective 25-6) Explain what is meant by prospective financial statements and distinguish between forecasts and projections. What four things are involved in an examination of prospective financial statements?

25-16 (Objective 25-8) State the reporting requirements for statements prepared on a basis other than GAAP.

25-17 (Objective 25-8) The Absco Corporation has requested that Herb Germany, CPA, provide a report to the Northern State Bank as to the existence or nonexistence of certain loan conditions. The conditions to be reported on are the working capital ratio, dividends paid on preferred stock, aging of accounts receivable, and competence of management. This is Herb’s first experience with Absco. Should Herb accept this engagement? Sub- stantiate your answer.

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS

25-18 (Objective 25-1) The following are miscellaneous questions about compilation and review services. Choose the best response.

a. It is acceptable for a CPA to be associated with financial statements when not inde- pendent with respect to the client and still issue a substantially unmodified report for which of the following:

(1) Audits of companies following GAAP.

(2) Audits of companies on a comprehensive basis of accounting other than GAAP. (3) Review of financial statements following GAAP.

(4) Compilation of financial statements following GAAP.

b. A CPA is performing review services for a small, closely held manufacturing company. As a part of the follow-up of a significant decrease in the gross margin for the current year, the CPA discovers that there are no supporting documents for $40,000 of disburse- ments. The chief financial officer assures her that the disbursements are proper. What should the CPA do?

(1) Include the unsupported disbursements without further work in the statements on the grounds that she is not doing an audit.

(2) Modify the review opinion or withdraw from the engagement unless the unsup- ported disbursements are satisfactorily explained.

(3) Exclude the unsupported disbursements from the statements.

(4) Obtain a written representation from the chief financial officer that the disburse-

ments are proper and should be included in the current financial statements.

c. Which of the following best describes the responsibility of the CPA in performing compilation services for a company?

(1) The CPA has to satisfy only himself or herself that the financial statements were

prepared in conformity with accounting standards.

(2) The CPA must understand thAepclieantg’s bousinPessDanFd accEounthingamnetchoedsrand read

the financial statements for reasonableness.

(3) TheCPAshouldobtainanunderstandingofinternalcontrolandperformtestsof

controls.

(4) The CPA is relieved of any responsibility to third parties.

25-19 (Objectives 25-3, 25-6) The following questions concern attestation engagements. Choose the best response.

a. Which of the following professional services is considered an attestation engagement? (1) A management consulting engagement to provide IT advice to a client.

(2) An income tax engagement to prepare federal and state tax returns.

(3) An engagement to report on compliance with statutory requirements.

(4) A compilation of financial statements from a client’s accounting records.

b. A Type 1 service auditor’s report on internal controls at a service organization

(1) includes an opinion about the suitability of the design of controls at the service

organization.

(2) is based on the performance of tests of controls and substantive tests of trans-

actions at the service organization.

(3) contains an opinion about the operating effectiveness of internal controls at the

service organization.

(4) provides an opinion about the fair presentation of the service organization’s

financial statements in accordance with accounting standards.

c. Which of the following statements concerning prospective financial statements is correct? (1) Only a financial forecast is normally appropriate for limited use.

(2) Anytypeofprospectivefinancialstatementisnormallyappropriateforlimiteduse. (3) Only a financial projection is normally appropriate for general use.

(4) Anytypeofprospectivefinancialstatementisnormallyappropriateforgeneraluse.

Chapter 25 / OTHER ASSURANCE SERVICES

809

810

25-20 (Objective 25-8) The following questions concern reports issued by auditors, other than those on historical financial statements. Choose the best response.

a. An auditor is reporting on cash basis financial statements. These statements are best referred to in the opinion of the auditor by which of the following descriptions?

(1) Cash receipts and disbursements and the assets and liabilities arising from cash

transactions.

(2) Financial position and results of operations arising from cash transactions.

(3) Balance sheet and income statements resulting from cash transactions.

(4) Cash balance sheet and the source and application of funds.

b. Which of the following statements with respect to an auditor’s report expressing an opinion on a specific item on a financial statement is correct?

(1) Such a report can be expressed only if the auditor is also engaged to audit the

entire set of financial statements.

(2) Materiality must be related to the specific item rather than to the financial state-

ments taken as a whole.

(3) The attention devoted to the specified item is usually less than it would be if the

financial statements taken as a whole were being audited.

(4) Theauditorwhohasissuedanadverseopiniononthefinancialstatementstakenasa

whole can never express an opinion on a specified item in these financial statements.

c . When asked to perform an audit to express an opinion on one or more specified elements,

accounts, or items of a financial statement, the auditor

(1) may not describe auditing procedures applied.

(2) should advise the client that the opinion can be issued only if the financial state-

ments have been audited and found to be fairly presented.

(3) mayassumethatthefirststandardofreportingwithrespecttoGAAPdoesnotapply.

(4) shouldcomplywiththerequestonlyiftheyconstituteamajorportionofthefinancial

statements on which an auditor has disclaimed an opinion based on an audit.

DISCUSSION QUESTIONS AND PROBLEMS

25-21 (Objective 25-1) Evaluate the following comments about compiled financial state- ments: “When CPAs associate their name with compiled financial statements, their only responsibility is to the client and that is limited to the proper summarization and presen- tation on the financial statements of information provided by the client. The opinion clearly states that the auditor has not conducted an audit and does not express an opinion on this fair presentation. If users rely on compiled financial statements, they do so at their own risk and should never be able to hold the CPA responsible for inadequate performance. Users should interpret the financial statements as if they had been prepared by management.”

25-22 (Objective 25-1) You are doing a review services and related tax work engagement for Murphy Construction Company. You have made extensive inquiries of management about their financial statements and have concluded that management has an excellent understanding of its business and is honest, but lacking in knowledge of technical account- ing issues. In doing the review you determine the following:

1. Repairs and maintenance expense has increased significantly compared to the preceding year. The president states that this seems to have been a year with a lot of repairs, in part because their equipment is getting older.

2. Property tax expense is the same as last year even though Murphy purchased a new building, including the land. The president states that there are no real estate taxes on the new building and land until next year.

3. Based on your knowledge of the construction industry you know that the pipes Murphy uses in construction have had a decrease in selling price to construction companies near the end of the current year. The president states that even though they have a large pipe inventory it will all be used in the next year or two, so the current price doesn’t matter because they won’t need to buy any.

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

 

4. Accounts receivable has increased almost 25% compared to the previous year, but the allowance for uncollectible accounts has stayed the same. The president states that even though receivables have increased, they still expect uncollectible accounts to be less than the stated allowance.

5. In discussions with the president you determine that there is a material uninsured lawsuit against the company from a former customer. The president believes it is a frivolous lawsuit and will not permit a footnote about it for fear that it will result in similar lawsuits from other customers.

a. Beyond inquiries and analytical procedures, what are the accountant’s responsibilities in performing review service engagements?

b. Describe what you should do in each of the preceding situations, assuming each one is material.

25-23 (Objective 25-1) SSARS contain several procedures that are required when engaged to perform a compilation or review engagement. Below are ten statements that may or may not be relevant to a compilation or review engagement. For each of the ten statements, indicate whether the procedure is to be performed in a compilation or review engagement.

Required

Required for a

Description of Procedure

1. Obtain a written engagement letter.

2. Understand the client’s industry and the nature of the

client’s business.

3. Read the financial statements.

4. Design and perform analytical procedures.

5. Make inquiries of client management.

6. Perform tests of controls.

7. Assess fraud risk.

8. Obtain a letter of representation from management.

Compilation Engagement?

Review Engagement?

 

9. Prepare documentation in sufficient detail to provide a clear understanding of the work performed.

10. Issue a report that contains limited assurance about whether the accountant is aware of the need for material modification to the financial statements.

25-24 (Objective 25-1) In an engagement to review the financial statements of a nonpublic company, SSARS require the accountant to obtain review evidence that is primarily based on inquiries and analytical procedures. The nature of the accountant’s inquiries is a matter of judgment. For example, the accountant may consider the nature and materiality of the items, likelihood of misstatement, how the items may be affected by management’s judgment, qualifications of client personnel, among other matters.

Below are several inquiry procedures for the sales and collection cycle:

Revenue

1. Are revenues from the sale of major products and services recognized in the appro- priate period?

Receivables

1. Has an adequate allowance been made for doubtful accounts? 2. Have receivables considered uncollectible been written off?

3. If appropriate, has interest been reflected?

4. Has a proper cutoff of sales transactions been made?

5. Are there any receivables from employees and related parties?

6. Are any receivables pledged, discounted, or factored?

7. Have receivables been correctly classified between current and noncurrent?

a. What other information about accounts receivable and revenue, besides the items listed, will the accountant have to obtain?

Required

Compare the illustrative procedures for review services and those commonly per- formed for audits. What are the major differences?

c. Of whom should the accountant make inquiries in a small, closely-held company?

d. Under what circumstances will procedures beyond those illustrated likely be performed? Be specific.

e. Compare the levels of achieved assurance for review services and audits. Is the achieved level much higher for audits, somewhat higher, or approximately the same? Give reasons for your answer.

25-25 (Objective 25-2) Lucia Johnson, of Johnson and Lecy, CPAs, has completed the first-year audit of Tidwell Publishing Co., a publicly held company, for the year ended December 31, 2011. She is now working on a review of interim financial statements for the quarter ended March 31, 2012.

Johnson has never done an interim review of a public company, but her firm does exten- sive compilation and review work. She therefore has one of her most experienced assistants, Fred Blair, do the work. She instructs him to follow the firm’s standard review services pro- cedures for SSARS reviews and to do high-quality work because Tidwell is a high-risk client.

Blair completes the review of Tidwell’s statements and Johnson carefully reviews Blair’s work. No exceptions are found. Each page of the client’s financial statements is marked “reviewed.” The following report is issued.

SECURITIES AND EXCHANGE COMMISSION

We have reviewed the accompanying balance sheet of Tidwell Publishing Co. as of March 31, 2012, and the related statements of income, retained earnings, and changes in financial position for the year then ended, in accordance with the standards of the Public Company Accounting Oversight Board (United States). All information included in these financial statements is the representation of the management of Tidwell Publishing Co.

A review consists principally of inquiries of company personnel and analytical

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

provider, report solely on the company’s IT availability policies and controls using the

Trust Services availability principle and criteria.

d. Management of Greenshield Technology, Inc. requested that its auditors perform a

WebTrust assurance services engagement on its e-commerce security policies. The CPA firm performed the WebTrust services as of April 30, 2011, and has not updated its work. Management wants its WebTrust seal to stay posted on its Web site through May 31, 2012.

Consider each request separately. Describe whether the requested assurance service can be performed.

25-27 (Objective 25-6) Carl Monson, the owner of Major Products Manufacturing Company, a small, successful, longtime audit client of your firm, has requested you to work with his company in preparing 3-year forecasted information for the year ending December 31, 2012, and two subsequent years. Monson informs you that he intends to use the forecasts, together with the audited financial statements, to seek additional financing to expand the business. Monson has had little experience in formal forecast preparation and counts on you to assist him in any way possible. He wants the most supportive opinion possible from your firm to add to the credibility of the forecast. He informs you that he is willing to do anything necessary to help you prepare the forecast.

First, he wants projections of sales and revenues and earnings from the existing business, which he believes can continue to be financed from existing capital.

Second, he intends to buy a company in a closely related business that is currently operating unsuccessfully. Monson states that he wants to sell some of the operating assets of the business and replace them with others. He believes that the company can then be made highly successful. He has made an offer on the new business, subject to obtaining proper financing. He also informs you that he has received an offer on the assets he intends to sell.

a. Explain circumstances under which it is and is not acceptable to undertake the engage-

Required

ment.

b. Why is it important that Monson understand the nature of your reporting requirements before the engagement proceeds?

c. What information will Monson have to provide to you before you can complete the forecasted statements? Be as specific as possible.

d. Discuss, in as specific terms as possible, the nature of the report you will issue with the forecasts, assuming that you are able to properly complete them.

25-28 (Objective 25-8) You have been requested by the management of J. L. Lockwood Co. to issue a debt compliance letter as a part of the audit of Taylor Fruit Farms, Inc. J. L. Lockwood Co. is a supplier of irrigation equipment. Much of the equipment, including that supplied to Taylor, is sold on a secured contract basis. Taylor Fruit Farms is an audit client of yours, but Lockwood is not. In addition to the present equipment, Lockwood informs you they are evaluating whether they should sell another $500,000 of equipment to Taylor Fruit Farms.

You have been requested to send Lockwood a debt compliance letter concerning the following matters:

1. The current ratio has exceeded 2.0 in each quarter of the unaudited statements pre- pared by management and in the annual audited statements.

2. Total owners’ equity is more than $800,000.

3. The company has not violated any of the legal requirements of California fruit-

growing regulations.

4. Management is competent and has made reasonable business decisions in the past 3 years.

5. Management owns an option to buy additional fruit land adjacent to the company’s

present property.

a. Define the purpose of a debt compliance letter.

b. Why is it necessary to conduct an audit of a company before it is acceptable to issue a

Required

debt compliance letter?

Chapter 25 / OTHER ASSURANCE SERVICES 813

Required

 

814

Required

c. For which of the five requested items is it acceptable for a CPA firm to issue a debt compliance letter? Give reasons for your answer.

25-29 (Objective 25-8) Bengston, CPA, is conducting the audit of Pollution Control Devices, Inc. In addition, a supplemental negative assurance report is required to a major mortgage holder. The supplemental report concerns indenture agreements to keep the client from defaulting on the mortgage. Total assets are $14 million and the mortgage is for $4 million. The major provisions of the indentures are as follows:

1. The current ratio must be maintained above 2.3 to 1.

2. The debt/equity ratio must be maintained below 3.0.

3. Net earnings after taxes must exceed dividends paid by at least $1 million.

a. Write the appropriate supplemental report if all three indenture agreement provisions have been satisfied.

b. How would the supplemental report change if net earnings after taxes were $1,010,000 and dividends paid were $60,000?

c. Assume the same situation as in part b and also assume that the client refuses to modify the financial statements or disclose the violation of the indenture agreement provisions on the grounds that the amount is immaterial. What is the nature of the appropriate auditor’s report?

d. What is the nature of the appropriate supplemental report if all the indenture agree- ment provisions have been satisfied but there is a lawsuit against the company that has resulted in disclosure of the lawsuit in a footnote to the financial statements?

25-30 (Objective 25-8) Jones, CPA, has completed the audit of Sarack Lumber Supply Co. and has issued a standard unqualified report. In addition to a report on the overall financial statements, the company needs a special audited report on three specific accounts: sales, net fixed assets, and inventory valued at FIFO. The report is to be issued to Sarack’s lessor, who bases annual rentals on these three accounts. Jones was not aware of the need for the report on the three specific accounts until after the overall audit was completed.

Required

a. Explain why Jones is unlikely to be able to issue the audit report on the three specific accounts without additional audit tests.

b. What additional tests are likely to be needed before the report on the three specific accounts can be issued?

c. Assuming that Jones is able to satisfy all the requirements needed to issue the report on the three specific accounts, write the report. Make any necessary assumptions.

INTERNET PROBLEM 25-1:

ACCOUNTING AND REVIEW SERVICES COMMITTEE

Required

The Accounting and Review Services Committee (ARSC) is responsible for issuing standards for compilations and reviews of financial statement issued by nonpublic companies. Visit the AICPA website (www.aicpa.org) and answer the following questions about the operations of this committee:

a. How many individuals serve on the ARSC and how are they chosen to serve?

b. What is the nature of the due process ARSC follows when developing and establishing

new standards?

c. How long must an exposure draft of a new standard (i.e., a new SSARS) be made

available for public comment?

d. How many affirmative votes are required before an exposure draft of a proposed or

final SSARS can be issued?

  1. Are meetings of the ARSC open to the public?

Chapter 26

REVIEW QUESTIONS

satisfy the audit requirements of all federal funding agencies

Special assignments—management requests for an operational audit for a specific pur- pose, such as investigating the possibility of fraud in a division or making recom- mendations for reducing the cost of a manufactured product

Statements on Internal Auditing Standards (SIASs)—statements issued by the Internal Auditing Standards Board of the IIA to provide authoritative interpretations of the IIA Practice Standards

Yellow Book—a publication of the GAO that is widely used as a reference by government auditors and CPAs who do governmental audit work; the official title is Government Auditing Standards

26-1 (Objective 26-1) Explain the role of internal auditors for financial auditing. How is it similar to and different from the role of external auditors?

26-2 (Objective 26-1) What is the nature of the two categories of standards in the IIA International Standards for the Professional Practice of Auditing?

26-3 (Objective 26-1) Explain the difference between the independence of internal

auditors and external auditors in the audit of historical financial statements. How can internal auditors best achieve independence?

26-4 (Objective 26-2) Explain how governmental financial auditing is similar to and different from audits of commercial companies. Who does governmental auditing?

26-5 (Objective 26-2) Explain what is meant by the Single Audit Act. What is its purpose? 26-6 (Objective 26-2) In what ways is the Yellow Book consistent with generally accepted

auditing standards, and what are some additions and modifications?

26-7 (Objective 26-2) Identify the primary specific objectives that must be incorporated into the design of audit tests under the Single Audit Act.

26-8 (Objective 26-2) Identify the key required reports of the Single Audit Act and OMB Circular A-133.

26-9 (Objective 26-3) Describe what is meant by an operational audit.

26-10 (Objective 26-3) Identify the three major differences between financial and opera-

tional auditing.

26-11 (Objective 26-4) Distinguish between efficiency and effectiveness in operational audits. State one example of an operational audit explaining efficiency and another explaining effectiveness.

26-12 (Objective 26-4) Distinguish among the following types of operational audits: functional, organizational, and special assignment. State an example of each for a not-for- profit hospital.

26-13 (Objective 26-4) Explain why many people think of internal auditors as the primary group responsible for conducting operational audits.

26-14 (Objective 26-4) Explain the role of government auditors in operational auditing. How is this similar to and different from the role of internal auditors?

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

26-15 (Objective 26-4) Under what circumstances are external auditors likely to be involved in operational auditing? Give one example of operational auditing by a CPA firm.

26-16 (Objective 26-5) Explain what is meant by the criteria for evaluating efficiency and effectiveness. Provide five possible specific criteria for evaluating effectiveness of an IT system for payroll.

26-17 (Objective 26-5) Identify the three phases of an operational audit.

26-18 (Objective 26-5) Explain how planning for operational auditing is similar to and

different from financial auditing.

26-19 (Objective 26-5) What are the major differences between reporting for operational and financial auditing?

MULTIPLE CHOICE QUESTIONS FROM CPA, CIA, AND CMA EXAMINATIONS

26-20 (Objectives 26-1, 26-4) The following questions deal with independence of auditors. Choose the best response.

a. The operational auditor’s independence is most likely to be compromised when the internal audit department is responsible directly to the

(1) vice president of finance. (4) executive vice president.

(2) president. (5) audit committee of the board of directors. (3) controller.

b. The independence of the internal audit department will most likely be assured if it reports to the

(1) president. (4) audit committee of the board of directors. (2) controller. (5) vice president of finance.

(3) treasurer.

c. You have been asked to assess the organizational independence of an internal audit activity. You should consider all of the following factors except

(1) functional reporting to the board and administrative reporting to the chief

executive officer.

(2) the criteria of education and experience considered necessary when filling vacant

positions on the internal audit staff.

(3) the degree to which internal auditors assume operational responsibilities.

(4) alimitationonthescopeofobjectivesfortheengagementsincludedinthereview.

26-21 (Objective 26-2) The following questions deal with governmental auditing. Choose the best response.

a. A governmental audit may extend beyond an examination leading to the expression of an opinion on the fairness of financial statement presentation to include

Program

Results

(1) Yes (2) Yes (3) No (4) Yes

Economy

Compliance and Efficiency

Yes No Yes Yes Yes Yes No Yes

b. When engaged to audit a governmental entity in accordance with Government Auditing Standards, an auditor prepares a written report on internal control

(1) on all audits, regardless of circumstances.

(2) only when the auditor has noted material weaknesses.

(3) only when requested by the governmental entity being audited. (4) only when requested by the federal government funding agency.

Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 831

832

c. Ward is auditing an entity’s compliance with requirements governing a major federal financial assistance program in accordance with the Single Audit Act. Ward detected noncompliance with requirements that have a material effect on the program. Ward’s report on compliance should express

(1) no assurance on the compliance tests.

(2) reasonable assurance on the compliance tests. (3) a qualified or adverse opinion.

(4) an adverse opinion or a disclaimer of opinion.

26-22 (Objectives 26-3, 26-4, 26-5) The following questions deal with operational auditing. Choose the best response.

a. Which of the following best describes the operational audit?

(1) It requires constant review by internal auditors of the administrative controls as

they relate to the operations of the company.

(2) It concentrates on implementing financial and accounting controls in a newly

organized company.

(3) Itattemptsandisdesignedtoverifythefairpresentationofacompany’sresultsof

operations.

(4) It concentrates on seeking aspects of operations in which waste would be reduced

by the introduction of controls.

b. The evaluation of audit field work of an operating unit should answer the following questions:

1. What are the reasons for the results? 2. How can performance be improved? 3. What results are being achieved?

What is the chronological order in which these questions should be answered?

(1) 3—1—2

c. The purpose of governmental effectiveness or program auditing is to determine if the desired results of a program are being achieved. The first step in conducting such an audit is to

(1) evaluate the system used to measure results.

(2) determine the time frame to be audited.

(3) collect quantifiable data on the program’s success or failure. (4) identify the legislative intent of the program being audited.

26-23 (Objectives 26-1, 26-4, 26-5) The following questions deal with internal auditing. Choose the best response.

a. Which of the following is generally considered to be a major reason for establishing an internal auditing function?

(1) To relieve overburdened management of the responsibility for establishing effec-

tive systems of internal control.

(2) To ensure that operating activities comply with the policies, plans, and procedures

established by management.

(3) To ensure the accuracy, reliability, and timeliness of financial and operating data

used in management’s decision making.

(4) To evaluate and improve the effectiveness of control processes.

b. The scope of an internal auditing engagement is initially defined by the

(1) engagement objectives.

(2) scheduling and time estimates.

(3) preliminary survey.

(4) engagement work program.

(2) 1—3—2

(3) 3—2—1 (4) 1—2—3 (5) 2—3—1

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

c. With regard to corrective action on audit results, which of the following is not the internal auditor’s responsibility?

(1) Solicitingauditees’suggestionsforcorrectiveactions.

(2) Recommending possible alternative corrective actions.

(3) Directing the corrective actions.

(4) Determining that the corrective actions are responsive to the audit results.

(5) Evaluating new policy statements to determine whether they address the unsatis-

factory conditions disclosed in the audit results.

26-24 (Objectives 26-1, 26-4) Lajod Company has an internal audit department consisting of a manager and three staff auditors. The manager of internal audits, in turn, reports to the corporate controller. Copies of audit reports are routinely sent to the audit committee of the board of directors as well as to the corporate controller and the individual respon- sible for the area or activity being audited.

The manager of internal audits is aware that the external auditors have relied on the internal audit function to a substantial degree in the past. However, in recent months, the external auditors have suggested there may be a problem related to the objectivity of the internal audit function. This objectivity problem may result in more extensive testing and analysis by the external auditors.

The external auditors are concerned about the amount of nonaudit work performed by the internal audit department. The percentage of nonaudit work performed by the internal auditors in recent years has increased to about 25% of their total hours worked. A sample of five recent nonaudit activities are as follows:

1. One of the internal auditors assisted in the preparation of policy statements on internal control. These statements included such things as policies regarding sensitive payments and standarAdspofacogntrol forPinDteFrnal cEontrohlsa. ncer

2. The bank statements of the corporation are reconciled each month as a regular assignment for one of the internal auditors. The corporate controller believes this strengthens internal controls because the internal auditor is not involved in the receipt and disbursement of cash.

3. The internal auditors are asked to review the budget data in every area each year for relevance and reasonableness before the budget is approved. In addition, an internal auditor examines the variances each month, along with the associated explanations. These variance analyses are prepared by the corporate controller’s staff after consul- tation with the individuals involved.

4. One of the internal auditors has recently been involved in the design, installation, and initial operation of a new computer system. The auditor was primarily con- cerned with the design and implementation of internal accounting controls and the computer application controls for the new system. The auditor also conducted the testing of the controls during the test runs.

5. The internal auditors are often asked to make accounting entries for complex trans- actions before the transactions are recorded. The employees in the accounting department are not adequately trained to handle such transactions. In addition, this serves as a means of maintaining internal control over complex transactions. The manager of internal audits has always made an effort to remain independent of the corporate controller’s office and believes that the internal auditors are objective and independent in their audit and nonaudit activities.

a. Define objectivity as it relates to the internal audit function. Required

b. For each of the five situations outlined, explain whether the objectivity of Lajod Company’s internal audit department has been materially impaired. Consider each situation independently.

c. The manager of audits reports to the corporate controller.

Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 833

CASES

834

Required

The director of internal auditing and assistant controller is in charge of the internal audit department and reports to the controller in corporate headquarters. Copies of inter- nal audit reports are sent routinely to Weston’s board of directors.

a. Explain the additional steps in terms of field work, preparation of recommenda- tions, and operating management review that ordinarily should be taken by Weston Corporation’s internal auditors as a consequence of the audit findings in the first situation (excessive turnover).

b. Discuss whether there are any objectivity problems with Weston Corporation’s internal audit department as revealed by the audit findings. Include in your discussion any recommendations to eliminate or reduce an objectivity problem, if one exists.

c. The internal audit department is part of the corporate controllership function, and copies of the internal audit reports are sent to the board of directors.

(1) Evaluate the appropriateness of the location of the internal audit department

within Weston’s organizational structure.

(2) Discuss who within Weston should receive the reports of the internal audit

department.*

26-26 (Objectives 26-4, 26-5) Haskin Company was founded 40 years ago and now has several manufacturing plants in the Northeast and Midwest. The evaluation of proposed capital expenditures became increasingly difficult for management as the company became geographically dispersed and diversified its product line. Thus, the Capital Budgeting Group was organized in 2010 to review all capital expenditure proposals in excess of $100,000.

*CMA adapted.

(1) Does this reporting relationship result in a problem of objectivity? Explain your answer.

(2) Would your answer to any of the five situations in requirement b have changed if the manager of internal audits reported to the audit committee of the board of directors? Explain your answer.*

26-25 (Objectives 26-1, 26-4, 26-5) Weston Corporation has an internal audit department operating out of the corporate headquarters. Various types of audit assignments are performed by the department for the eight divisions of the company. The following findings resulted from recent audits of Weston Corporation’s White Division:

1. One of the departments in the division appeared to have an excessive turnover rate. Upon investigation, the personnel department seemed to be unable to find enough workers with the specified skills for this department. Some workers are trained on the job. The departmental supervisor is held accountable for labor efficiency variances but does not have qualified staff or sufficient time to train the workers properly. The supervisor holds individual workers responsible for meeting pre- determined standards from the day they report to work. This has resulted in a rapid turnover of workers who are trainable but not yet able to meet standards.

2. The internal audit department recently participated in a computer feasibility study for this division. It advised and concurred on the purchase and installation of a specific computer system. Although the system is up and operating, the results are less than desirable. The software and hardware meet the specifications of the feasi- bility study, but there are several functions unique to this division that the system has been unable to accomplish. Linking of files has been a problem. For example, several vendors have been paid for materials not meeting company specifications. A revision of the existing software is probably not possible, and a permanent solution probably requires replacing the existing computer system with a new one.

3. One of the products manufactured by this division was recently redesigned to eliminate a potential safety defect. This defect was discovered after several users were

injured. At present, there are no pending lawsuits because none of the injured parties has identified a defect in the product as a cause of the injury. There is insufficient information to determine whether the defect was a contributing factor.

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

The Capital Budgeting Group conducts its annual planning and budget meeting each September for the upcoming calendar year. The group establishes a minimum return for investments (hurdle rate) and estimates a target level of capital expenditures for the next year based on the expected available funds. The group then reviews the capital expenditure proposals that have been submitted by the various operating segments. Proposals that meet either the return on investment criterion or a critical need criterion are approved to the extent of available funds.

The Capital Budgeting Group also meets monthly, as necessary, to consider any projects of a critical nature that were not expected or requested in the annual budget review. These monthly meetings allow the Capital Budgeting Group to make adjustments during the year as new developments occur.

Haskin’s profits have been decreasing slightly for the past 2 years despite a small but steady sales growth, a sales growth that is expected to continue through 2012. As a result of the profit stagnation, top management is emphasizing cost control and all aspects of Haskin’s operations are being reviewed for cost reduction opportunities.

Haskin’s internal audit department has become involved in the companywide cost reduction effort. The department has already identified several areas where cost reductions could be realized and has made recommendations to implement the necessary procedures to effect the cost savings. Tom Watson, internal audit director, is now focusing on the activities of the Capital Budgeting Group in an attempt to determine the efficiency and effectiveness of the capital budgeting process.

In an attempt to gain a better understanding of the capital budgeting process, Watson decided to examine the history of one capital project in detail. A capital expenditure proposal of Haskin’s Burlington Plant that was approved by the Capital Budgeting Group in 2011 was selected randomly from a population of all proposals approved by the group at its 2010 and 2011 annual planning and budget meetings.

The Burlington proposal consisted of a request for five new machines to replace equip-

ment that was 20 years old and for which preventive maintenance had become expensive.

Four of the machines were for replacement purposes, and the fifth was for planned growth

in demand. Each of the four replacement machines was expected to result in annual maintenance cost savings of $20,000. The fifth machine was exactly like the other four and was expected to generate an annual contribution of $30,000 through increased output. Each machine had a cost of $110,000 and an estimated useful life of 8 years.

a. Identify and discuss the issues that Haskin Company’s internal audit department must Required address in its examination and evaluation of Burlington Plant’s 2011 capital expendi-

ture project.

b. Recommend procedures to be used by Haskin’s internal audit department in the audit review of Burlington Plant’s 2011 capital expenditure project.*

26-27 (Objectives 26-4, 26-5) Lecimore Company has a centralized purchasing department that is managed by Joan Jones. Jones has established policies and procedures to guide the clerical staff and purchasing agents in the day-to-day operation of the department. She is satisfied that these policies and procedures are in conformity with company objectives and believes there are no major problems in the regular operations of the purchasing department.

Lecimore’s internal audit department was assigned to perform an operational audit of the purchasing function. Their first task was to review the specific policies and procedures established by Jones. The policies and procedures are as follows:

• All significant purchases are made on a competitive bid basis. The probability of timely delivery, reliability of vendor, and so forth, are taken into consideration on a subjective basis.

• Detailed specifications of the minimum acceptable quality for all goods purchased are provided to vendors.

• Vendors’ adherence to the quality specifications is the responsibility of the materials manager of the inventory control department and not the purchasing department. The

*CMA adapted.

Chapter 26 / INTERNAL AND GOVERNMENTAL FINANCIAL AUDITING AND OPERATIONAL AUDITING 835

836

Required

materials manager inspects the goods as they arrive to be sure that the quality meets the minimum standards and then sees that the goods are transferred from the receiving dock to the storeroom.

• All purchase requests are prepared by the materials manager based on the production schedule for a 4-month period.

The internal audit staff then observed the operations of the purchasing function and gathered the following findings:

• One vendor provides 90% of a critical raw material. This vendor has a good delivery record and is reliable. Furthermore, this vendor has been the low bidder over the past few years.

• As production plans change, rush and expedite orders are made by production directly to the purchasing department. Materials ordered for cancelled production runs are stored for future use. The costs of these special requests are borne by the purchasing department. Jones considers the additional costs associated with these special requests as “costs of being a good member of the corporate team.”

• Materials to accomplish engineering changes are ordered by the purchasing depart- ment as soon as the changes are made by the engineering department. Jones is proud of the quick response by the purchasing staff to product changes. Materials on hand are not reviewed before any orders are placed.

• Partial shipments and advance shipments (that is, those received before the requested date of delivery) are accepted by the materials manager, who notifies the purchasing department of the receipt. The purchasing department is responsible for follow-up on partial shipments. No action is taken to discourage advance shipments.

Based on the purchasing department’s policies and procedures and the findings of Lecimore’s internal audit staff,

a. Identify deficiencies and/or inefficiencies in Lecimore Company’s purchasing function. b. Make recommendations for those deficiencies/inefficiencies that you identify.*

UseAthpe faollgowoing foPrmDaFt in pErepnarhingaynoucr respronse:

Deficiencies/Inefficiencies Recommendations

1. 1.

26-28 (Objectives 26-4, 26-5) Superior Co. manufactures automobile parts for sale to the major U.S. automakers. Superior’s internal audit staff is to review the internal controls over machinery and equipment and make recommendations for improvements when appro- priate. The internal auditors obtained the following information during the assignment:

• Requests for purchase of machinery and equipment are normally initiated by the supervisor in need of the asset. The supervisor discusses the proposed acquisition with the plant manager. A purchase requisition is submitted to the purchasing department when the plant manager is satisfied that the request is reasonable and that there is a remaining balance in the plant’s share of the total corporate budget for capital acquisitions.

• Upon receiving a purchase requisition for machinery or equipment, the purchasing department manager looks through the records for an appropriate supplier. A formal purchase order is then completed and mailed. When the machine or equipment is received, it is immediately sent to the user department for installation. This allows the economic benefits from the acquisition to be realized at the earliest possible date.

• The property, plant, and equipment ledger control accounts are supported by computerized depreciation lapse schedules organized by year of acquisition. These lapse schedules are used to compute depreciation as a unit for all assets of a given type that are acquired in the same year. Standard rates, depreciation methods, and salvage values are used for each major type of fixed assets. These rates, methods, and salvage values were set 10 years ago during the company’s initial year of operation.

• When machinery or equipment is retired, the plant manager notifies the accounting department so that the appropriate entries can be made in the accounting records.

*CMA adapted.

Part 6 / OTHER ASSURANCE AND NONASSURANCE SERVICES

 

• There has been no reconciliation since the company began operations between the accounting records and the machinery and equipment on hand.

Identify the internal control deficiencies and recommend improvements that the internal audit staff of Superior Co. should include in its report regarding the internal controls over fixed assets. Use the following format in preparing your answer:*

Deficiencies Recommendations

1. 1.

Required

INTERNET PROBLEM 26-1: INSTITUTE OF INTERNAL AUDITORS

The Institute of Internal Auditors (IIA) is an international professional association of more than 170,000 members with global headquarters in Altamonte Springs, Florida. Throughout the world, The IIA is recognized as the internal audit profession’s leader in certification, education, research, and technical guidance. Visit the IIA’s website (www.theiia.org) to answer questions about the IIA and certification of internal auditors.

a. Why should an organization have an internal auditing department? (Hint: open Required “frequently asked questions” under the “About the Internal Audit Profession” link.)

b. What are the six steps to receiving a certification in internal auditing?

c. What certifications are available to internal auditors?

d. What are the four parts of the CIA exam? How are the requirements for passing the CIA exam similar to and different from the CPA exam?