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Auditing Solutions Chapter 1-20
Financial Auditing and Ethics (Central Queensland University)
StudeerSnel wordt niet gesponsord of ondersteund door een hogeschool of universiteit
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CHAPTER 1
AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING
Answers to Review Questions
1-1
The study of auditing is more conceptual in nature compared to other accounting
courses. Rather than focusing on learning the rules, techniques, and computations required to
prepare financial statements, auditing emphasizes learning a framework of analytical and logical
skills to evaluate the relevance and reliability of the systems and processes responsible for
financial information, as well as the information itself. To be successful, students must learn the
framework and then learn to use logic and common sense in applying auditing concepts to
various circumstances and situations.
Understanding auditing can improve the decision making ability of consultants, business
managers, and accountants by providing a framework for evaluating the usefulness and
reliability of information.
1-2
There is a demand for auditing in a free-market economy because the agency
relationship between an absentee owner and a manager produces a natural conflict of interest
due to the information asymmetry that exists between the owner and manager. As a result, the
agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a
cost-effective form of monitoring.
The empirical evidence suggests auditing was demanded prior to government regulation
such as statutory audit requirements. Additionally, many private companies and other entities
not subject to government auditing regulations also demand auditing.
1-3
The agency relationship between an owner and manager produces a natural conflict of
interest because of differences in the two parties’ goals and because of information asymmetry
that exists between them. That is, the manager generally has more information about the ‘true’
financial position and results of operations of the entity than the absentee owner does. If both
parties seek to maximize their own self-interest, it is likely that the manager will not act in the
best interest of the owner and may manipulate the information provided to the owner
accordingly.
1-4
Independence is an important standard for auditors. If an auditor is not independent of
the client, users may lose confidence in the auditor’s ability to report truthfully on the financial
statements, and the auditor’s work loses its value. From an agency perspective, if the principal
(owner) knows that the auditor is not independent, the owner will not trust the auditor’s work.
Thus, the agent will not hire the auditor because the auditor’s report will not be effective in
reducing information risk from the perspective of the owner.
1-5
Auditing (broadly defined) is a systematic process of objectively obtaining and
evaluating evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between those assertions and established criteria and
communicating the results to interested users.
Assurance is engagement in which a practitioner expresses a conclusion designed to
enhance the degree of confidence of the intended users other than the responsible party about
the outcome of the evaluation or measurement of a subject matter against criteria.
Examples of assurance services are assurance (audit) of financial statements,
assurance of prospective financial information, assurance of reporting on internal control,
assurance of sustainability reporting, and assurance of electronic commerce.
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1-6
The phrase systematic process implies that there should be a well-planned, logical
approach for conducting an audit that involves objectively obtaining and evaluating evidence.
1-7
Materiality: "Omissions or misstatements of items are material if they could, individually
or collectively, influence the economic decisions of users taken on the basis of the financial
statements. Materiality depends on the size and nature of the omission or misstatement judged
in the surrounding circumstances. The size or nature of the item, or a combination of both, could
be the determining factor." (IASB).
Audit risk is defined as the risk that the auditor expresses an inappropriate audit opinion
when the financial statements are materially misstated (ISA 200).
The audit report states that the auditor obtains “reasonable assurance” whether the
financial statements are free from “material” misstatement. The term reasonable assurance
informs the reader that there is some level of risk that the audit did not detect all material
misstatements. In addition, the auditor’s opinion commonly uses the wording that the financial
statements present fairly, “in all material respects.” These phrases communicate to third parties
that the audit report is limited to material information.
1-8
On most audits, it is not feasible or cost-effective to audit all transactions. For example,
in a small business, the auditor might be able to examine all transactions that occurred during
the period. However, it is unlikely that the owner of the business could afford to pay for such an
extensive audit. For a large organization, the sheer volume of transactions prevents the auditor
from examining every transaction. Thus, there is a trade-off between the exactness or precision
of the audit and its cost.
1-9
The major phases of the audit are:
• Client acceptance/continuance and establishing engagement terms
• Preplanning
• Assess risks and establish materiality
• Plan the audit
• Consider internal control
• Audit business processes and related accounts
• Complete the audit
• Evaluate results and issue audit report
1-10
The auditor’s understanding of the entity and its environment includes knowledge
about: (1) the nature of the entity, (2) its objectives and strategies, (3) its industry, regulatory,
and other external factors, (4) its management, (5) its governance, (6) its measurement and
performance process, and (7) its business processes.
1-11
Sometimes auditors will face situations where no standard audit procedure exists, such
as the example from the text of verifying the inventory of reindeer. Such circumstances require
that the auditor possess creativity and innovation when planning and administering audit
procedures where little or no precedent exists. Every client is different, and applying auditing
concepts in different situations requires logic and common sense, and frequently creativity and
innovation.
Solutions to Problems
1-12
The memo should cite the following facts:
• There is a historical relationship between accounting and auditing.
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•
•
•
When parties to the agency relationship (contract) do not possess the same amount
of information (information asymmetry) there is a natural conflict of interest between
the parties. For example, when an owner and manager are negotiating an
employment contract, the owner may assume that the manager likely will use
organizational funds for personal uses. Auditing plays an important role in such
relationships. The owner and manager will consummate an employment contract
only if the manager agrees to be monitored. Auditing can be used to monitor the
contract agreed to by the two parties. (P.S. As a lawyer, Lee should be well versed
on contract law.)
Auditing is also used to monitor other types of contracts for which no laws or
regulations require an audit, for example, contracts between management and debt
holders.
There is historical evidence of forms of auditing in the early Greek states and in the
United Kingdom during the industrial revolution. Additional evidence for the demand
for auditing is also provided by the fact that many private companies and other
entities not subject to a statutory audit requirement contract for audits.
1-13
There are two major factors that may make an audit necessary for Greenbloom Garden
Centers. First, the company may require long-term financing for its expansion into other cities.
Entities such as banks or insurance companies are likely to be the sources of the company’s
debt financing. These entities may require audited financial statements before lending
significant funds and require audited financial statements during the time period the debt is
outstanding. There is information asymmetry between the lender of funds and the owner of the
business, and this asymmetry results in information risk to the lender. Even if the business
could get funding without an audit, a standard audit report with an unmodified opinion by a
reputable auditor might very well reduce the lender’s information risk and make the terms of the
loan more favorable to the owner. Second, as the company grows, the family will lose control
over the day-to-day operations of the stores. An audit can provide an additional monitoring
activity for the family in controlling the expanded operations of the company.
1-14 a. Evidence supporting the financial statements consists of the underlying accounting
data and all corroborating information available to the auditor.
b. Management makes assertions about components of the financial statements. For
example, an entity's financial statements may contain a line item that accounts receivable are
€1,750,000. In this instance, management is asserting, among other things, that the entity owns
the receivable and that the receivables are properly valued (i.e., net realizable value). Audit
evidence helps the auditor determine whether management’s assertions are being met. If the
auditor is comfortable that he or she can provide reasonable assurance that all assertions are
met for all accounts, he or she can issue an audit report with an unmodified opinion.
c. In searching for and evaluating evidence, the auditor should be concerned with the
relevance and reliability of evidence. If the auditor relies on evidence that relates to a different
assertion from the one being tested, an incorrect conclusion may be reached about the
management assertion. Reliability refers to the ability of evidence to signal the true state of the
assertion.
1-15 The auditor’s understanding is obtained during the first two boxes shown in Figure 1-3—
Client Acceptance/Continuance and Pre-Planning. The intervening steps include:
Assess Risks and Establish Materiality In order to properly plan the audit, the audit team
must make a preliminary assessment of the client’s business risks and establish a preliminary
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judgment about materiality. The audit team relies on these assessments to then assess risk
relating to the likelihood of material misstatements in the financial statements. The auditor’s risk
assessments and materiality judgment are used to define the scope for the audit.
Plan the Audit In developing the audit plan, the auditor should be guided by (1) the
procedures performed to gain and document an understanding of the entity and (2) the results
of the risk assessment process. The auditor may conduct preliminary analytical procedures to
identify specific transactions or account balances that should receive special attention due to an
increased risk of material misstatement. The auditor should prepare a written audit plan that
sets forth, in reasonable detail, the nature, extent, and timing of the audit work. The audit
partner or manager should discuss with other members of the audit team the susceptibility of
the entity to material misstatements due to error or fraud.
Consider Internal Control When obtaining an understanding of the entity and its
environment, the auditor should gain an understanding of internal control sufficient to assess the
risk of material misstatement, plan the audit by performing procedures to understand the design
of controls relevant to the audit, and determine whether they have been implemented. The
auditor then evaluates the internal controls in order to assess the risk that they will not prevent
or detect a material misstatement in the financial statements. (Note that Chapter 7 covers the
audit of internal control for public companies in the U.S.)
Audit Business Processes and Related Accounts Based on the knowledge of the entity and
its environment, the auditor determines the audit procedures that are necessary to reduce the
risk of material misstatement to a low level for the financial statement accounts affected by a
particular business process. The individual audit procedures are then directed toward specific
assertions in the account balance that are likely to be misstated.
Complete the Audit After the auditor has completed testing the account balances, the
sufficiency of the evidence gathered needs to be evaluated. The auditor must obtain sufficient
appropriate evidence in order to reach and justify a conclusion on the fairness of the financial
statements. The auditor also assesses the possibility of contingencies, and searches for any
events subsequent to the balance sheet date that may impact the financial statements. Chapter
17 covers each of these issues in detail.
1-16 a.
The major phases of the audit and their descriptions are (also see solution to 115, above):
1.
Client acceptance/continuance and establish the terms of the engagement. The auditor
decides to accept a new client or to retain an existing client. The auditor establishes an
understanding with the client regarding the services to be performed.
2. Preplanning. This phase involves (1) determining the audit engagement team
requirements and (2) ensuring the independence of the audit team and audit firm.
3. Establish materiality and assess risks. The auditor establishes the preliminary
judgment about materiality and makes a preliminary assessment of the client’s
business risks.
4.
Plan the audit. During this phase of the audit, the auditor uses the knowledge of the
client to plan the audit and perform preliminary analytical procedures. The purpose is of this
phase to plan an effective and efficient audit.
5.
Consider internal control. The auditor understands and evaluates the client’s internal
controls in order to assess the risk that they will not prevent or detect a material misstatement.
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6.
Audit business processes and related accounts. The auditor conducts substantive tests,
including analytical procedures and the details of the account balances searching for material
misstatements.
7.
Complete the audit. The auditor searches for contingencies and subsequent events,
and performs a final review of the evidence gathered.
8.
Issue the audit report. Based on the collection and evaluation of evidence, the auditor
issues a report on the fair presentation of the financial statements.
b.
While audit procedures may be designed to test a specific assertion, they may
simultaneously provide evidence on another account or assertion. An example would be when
an auditor obtains evidence about a client’s transactions affecting the inventory account and
whether sales of inventory were included in the proper period. Such evidence may also be
relevant to the client’s assertions regarding whether accounts receivable balances were correct
at the end of the period.
c.
Auditors develop an understanding of an entity's internal control in order to establish the
scope of the audit. However, during the course of this work, the auditor may become aware of
material weaknesses in the entity's accounting systems. The auditor is required to
communicate this information to management or those charged with governance (e.g., the
board of directors). The auditor may also make suggestions on how to correct the weaknesses.
The auditor's work on internal control may also have a preventive effect on the entity's
employees. If the employees know that their work will be audited, they are less likely to commit
errors or fraud.
Solutions to Discussion Case
1-17 a.
In the discussion case the Office of Auditor General (OAG) has examined banks
in financial difficulties. In most countries such Office or other regulatory bodies (e.g., a Financial
Supervisory Authority) have supervision and examination responsibilities for banks.
These bodies normally exercise their regulatory
supervision and examination duties through on-site and off-site evaluations of banks’ financial
condition and safety and soundness practices. On-site evaluations typically involve inquiries of
bank management personnel, reviews of bank financial accounting records, and a review of
bank operating policies and procedures. Off-site monitoring involves review and analysis of
reports such as quarterly reports and other information requested by the regulator.
In the discussion case OAG reviewed the 7 banks with financial difficulties by obtaining
and reviewing key documents. This included recent reports and audited financial statements
prepared by bank management, and reports of examination and reviews prepared by the
regulators. Each of the reports was reviewed, their contents were summarized and analyzed,
and the reports were compared to determine if they provided adequate and timely disclosure of
the true nature of the banks' financial condition prior to the financial difficulties.
The OAG did not review the specific application of auditing standards used by the
independent auditors in reaching their opinion on these banks. The criteria used by OAG to
evaluate the adequacy and degree of compliance with the requirements were relevant laws and
regulations, as well as the financial reporting framework. Some of the key findings by the OAG
were:
• Reports had failed to provide early warnings of impaired asset values. This occurred
because existing financial reporting framework had allowed too much latitude in
determining the carrying amounts for problem loans and repossessed collateral.
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•
Pervasive internal control weaknesses had contributed to the financial difficulties.
There had been serious breakdowns in corporate governance, including
inadequacies in board of director activities. The OAG also noted that there had been
weaknesses in operating management and loan portfolio management.
b.
Independent audits are a critical component of corporate
governance and can enhance the effectiveness of the examination and supervision process.
Audits of quarterly reports will improve the timeliness of reliable financial reports and help
identify internal control weaknesses. Thus, such audits can benefit bank examiners in
enhancing the safety and soundness of financial institutions.
Solutions to Internet Assignments
1-18 There are numerous Internet sites that contain accounting and auditing information.
Following are some suggested sites:
• The International Federation of Accountants (www.ifac.org) web site provides detailed
information on the organization, its boards and committees, and its pronouncements,
including the IFAC Code of Ethics for Professional Accountants and the International
Auditing and Assurance Standards Board’s (IAASB) International Standards on Auditing
(ISAs). The IFAC site also includes links to its more than 160 member organizations.
• The International Accounting Standards Board’s (IASB) home page (www.iasb.org/) contains
information on the organization, its standards, and its publications.
• The International Organization of Securities Commissions (IOSCO) home site
(www.iosco.org/) contains information about IOSCO, its publications, and links to its member
bodies and other relevant organizations.
• The International Organization of Supreme Audit Institutions (INTOSAI) web site
(www.intosai.org/) contains information about INTOSAI, its committees, standards, and links
to its member bodies.
• The Institute of Internal Auditors home page (www.theiia.org) contains detailed information
on internal auditing.
• The Association of Certified Fraud Examiners home page (www.cfenet.com) contains
extensive information on the Association’s certification as Certified Fraud Examiners (CFE).
• The European Commission Internal Market DG home site
(europa.eu.int/comm/internal_market/financial-reporting/index_en) contains information on
accounting and auditing in the Internal Market in the European Union.
• Fédération des Experts Comptables Européens (FEE) web site (www.fee.be/) contains
information about FEE, its publication, and numerous European and international links.
• The European Accounting Association’s (EAA) home site (www.eaaonline.org/associations/eaa/index.asp) contains information on accounting scholars and
research activities in Europe.
• The American Institute of Certified Public Accountant’s (AICPA) home page (www.aicpa.org)
contains extensive information on the organization's activities.
• The American Accounting Association’s home page (www.aaahq.org) contains information
on accounting scholar and research activities in the U.S. and numerous links, including to
professional organizations, accounting journals, and education sites.
•
The U.S. Securities and Exchange Commission’s (SEC) Edgar Web site (www.sec.gov)
contains all filings by public companies with the U.S. Securities and Exchange Commission
(SEC). It also contains information on other activities by the SEC.
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The Public Company Accounting Oversight Board’s (PCAOB) web site (www.pcaobus.org/)
offers detailed information about the PCAOB and its standards.
•
The major public accounting firms and many smaller firms also maintain web sites.
•
1-19 A search of the Internet will identify a number of potential sources for information on the
mail order industry. Some suggestions are:
• Pegasus Research International, LLC (www.mindbranch.com/) maintains a home
page that contains statistics on E-commerce and the state of the Internet.
• MarketResearch.Com’s home site (www.marketresearch.com/) provides
information on e-commerce and the mail order industry.
• The International Society for Strategic Marketing (www.issm.org) maintains a site
that contains information and statistics on international direct marketing.
• Retail Net’s home page (www.retailnet.com/) provides information on the retail
marketplace industry, including the catalogue and mail order industry.
• Lastly, a number of the major public accounting firms have industry specialization
in retail. The sites of the firms contain information on the retail industry.
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CHAPTER 2
THE FINANCIAL STATEMENT AUDITING ENVIRONMENT
Answers to Review Questions
2-1
During the late 1990s and early 2000s, firms aggressively sought opportunities to
expand their operations in non-audit services such as consulting. This expansion from their
core audit practice, combined with allegations of auditors refusing to challenge management’s
actions (including widespread earnings management), resulted in tension between regulators
and the accounting profession. Auditors’ independence issues gained renewed focus. Major
audit firms started reorganizing their portfolio of non-audit services offered. IFAC as well as
regulators issued new rules on auditor independence. However, subsequent financial fiascos
such as those at Ahold, Enron, Parmalat, WorldCom, Tyco, and many others, caused investors
to doubt the fundamental integrity of the financial reporting system. Under pressure to restore
the public’s confidence, both the auditors and their professional organizations (e.g. IFAC and
IAASB), and regulators took action, resulting in more public oversight of the profession and
stricter regulations. The responsiveness of the profession to the needs of the public, investors
and regulators will be crucial for future regulatory measures.
2-2
The accounting profession’s expansion into new areas, combined with changes in the
overall business environment, resulted in new regulations and guidelines. The scandals of the
late 1990s and early 2000s brought into the question the profession’s ability to self-regulate,
resulting in more public oversight of the profession and new regulations. While these changes
have caused pain and turmoil, they highlight the essential importance of auditing in our
economic system. Ultimately, the “back to basics” emphasis, along with auditing firms’ renewed
focus on thorough and effective financial statement audits, will likely prove healthy for the
financial reporting systems and for the profession.
2-3
The essential components of the high-level model of business offered in the chapter are:
corporate governance, objectives, strategies, processes, controls, transactions, and financial
statements. Corporate governance is carried out by management and the board of directors
(supervisory board) in order to ensure that business objectives are carried out and that
company assets are safeguarded. To achieve its objectives, management must formulate
strategies and implement various processes which are in turn carried out through business
transactions. The entity’s information and internal control systems must be designed to ensure
that these transactions are properly executed, captured, and processed in order to produce
accurate financial statements. It is important that the auditor obtain a firm understanding of
these components in order to plan the nature, timing, and extent of the audit so that it is efficient
and effective.
2-4
The information system must maintain a record of all businesses transactions. It should
be capable of producing accurate financial reports to summarize the effects of the entity’s
transactions. Internal control is required to ensure that transactions are appropriately conducted
and recorded by the information system and company employees. They provide safeguards to
ensure the 1) reliability of financial reporting, 2) compliance with laws and regulations, and 3)
the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain
an understanding of internal control in planning the nature, timing, and extent of testing.
2-5
The three categories of management assertions cover every aspect of what is needed
for a transaction to be handled properly, for a financial statement account to be fairly stated, and
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for the financial statements to be presented appropriately and to contain adequate disclosures.
The management assertions form the basis for planning and evaluating the evidence that the
auditor must obtain about the fairness of the client’s financial statements.
2-6
The five IAASB categories of standards are: International Standards on Quality Control
(ISQCs), International Standards on Auditing (ISAs), International Standards on Review
Engagements (ISREs), International Standards on Assurance Engagements (ISAEs), and
International Standards on Related Services (ISRSs). ISAs are grouped into categories:
Introductory Matters (currently no standards), General Principles and Responsibilities, Risk
Assessment and Response to Assessed Risks, Audit Evidence, Using Work of Others, Audit
Conclusions and Reporting, and Specialized Areas.
2-7
Independence is an important standard for auditors. If an auditor is not independent of
the client, users may lose confidence in the auditor’s ability to report truthfully on the financial
statements, and the auditor’s work loses its value. From an agency perspective, if the principal
(owner) knows that the auditor is not independent, the owner will not trust the auditor’s work.
Thus, the agent will not hire the auditor because the auditor’s report will not be effective in
reducing information risk from the perspective of the owner.
2-8
Management is responsible to prepare financial statements, in accordance with the
applicable financial reporting framework, that fairly present the company’s financial condition
and operations. The auditor is responsible to issue an opinion in regards to the financial
statements prepared by management. In order to issue this opinion, the auditor must plan and
perform the audit in accordance with established standards to obtain reasonable assurance that
the financial statements are free of material misstatement, whether caused by error or fraud.
However, it is important to note that an auditor’s unmodified opinion does not mean that errors
or fraud do not exist but rather that there is reasonable assurance that they do not exist in
material amounts.
2-9
There are nine elements of the auditor's standard report with an unmodified opinion on
the financial statements: (1) the title, (2) the addressee, (3) the introductory paragraph, (4)
management’s responsibility, (5) auditor’s responsibility, (6) auditor’s opinion, (7) auditor’s
signature, (8) the date of the report, and (9) auditor’s address. In some jurisdictions the auditor
has additional responsibilities to report on other matters that are supplementary to expressing
an opinion on the financial statements. Such reporting is addressed in a separate section after
the auditor’s opinion on the financial statements.
An unqualified audit report for a public company also contains an explanatory paragraph
referring to the audit of internal control, as illustrated in this chapt
2-10
Examples of compliance assurance (audits) include (1) internal auditors
determining whether corporate rules and policies are being followed by departments within the
organization, and (2) an examination of tax returns of individuals and companies by the tax
authorities for compliance with the tax laws.
Examples of operational assurance (audits) include (1) assurance (an audit) by the Medicines
Control Agency to determine the efficiency and effectiveness of procedures for introducing new
medicine to the market, (2) internal auditors examining the effectiveness and efficiency of funds
being spent on the entity’s computer resources, and (3) a university hiring an external auditor to
examine the effectiveness and efficiency of student advisory services.
Examples of forensic assurance (audits) include (1) an examination by an external auditor of
cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law
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enforcement body in tracing laundered monies by organized criminals, and (3) an independent
auditor helping identify hidden assets as part of a divorce settlement.
2-11
Auditors can be classified under four types: (1) external auditors, (2) internal auditors,
(3) government auditors, and (4) forensic auditors.
2-12 The Public Interest Oversight Board (PIOB) is an independent body charged with the
oversight of the public interest activities of IFAC. The IFAC Council is responsible for deciding
constitutional questions and electing the IFAC Board. The IFAC Board is responsible for
setting policy and overseeing IFAC operations, the implementation of programs, and the work of
IFAC committees and task forces. The Compliance Advisory Panel (CAP) is the IFAC
administration’s instrument to oversee the implementation and operation of the Member Body
Compliance Program. The Forum of Firms (FOF) is an organization of international audit firms
that perform audits of financial statements that are used across national borders. The
Transnational Auditors Committee (TAC) is the executive committee of FOF. The
International Auditing and Assurance Standards Board (IAASB) develops and issues the
international standards on auditing, assurance, quality control, and related services, as well as
practice statements. The Ethics Committee issues ethics standards. The Education
Committee develops guidelines related to the education of accountants. The International
Public Sector Accounting Standards Board (IPSASB) issues International Public Sector
Accounting Standards. The Professional Accountants in Business (PAIB) develops good
practice guidelines on issues affecting professional accountants in business, including
guidelines on corporate code of ethical conduct. Statements on Standards for Tax Services
2-13
The International Accounting Standards Board (IASB) publishes the International
Financial Reporting Standards (IFRSs) and has adopted the International Accounting Standards
(IASs). IFAC and IAASB strongly support the work of IASB in the setting and promotion of the
international accounting standards. When a particular financial reporting framework or specific
accounting rules are referred to in an ISA, the reference is to IASs/IFRSs.
The International Organization of Securities Commissions (IOSCO) organizes national
securities commissions. IOSCO cooperate closely with IFAC. (For example, IOSCO
participates in the IAASB Consultative Advisory Group (CAG) and in the selection of the
members of IFAC Public Interest Oversight Board (PIOB).) IFAC has sought IOSCO’s
endorsement of the IAASB standards for use in all the capital markets regulated by IOSCO
members.
The International Organization of Supreme Audit Institutions (INTOSAI) assembles national
Supreme Audit Institutions. INTOSAI cooperates closely with IAASB in projects relevant for
public sector auditing. INTOSAI has issued Auditing Standards to financial audits in the public
sector. In its goal of developing guidelines for financial audits for application of the Standards,
IOSCO has resolved that the guidelines should, as far as possible, draw upon the ISAs.
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Solutions to Problems
2-14
Brief References to IFAC Code of
Ethics and International Standards on
Auditing
Sally Jones’ Actions Resulting in
Failure to Comply with IFAC Code of
Ethics and International Standards
on Auditing
IFAC Code of Ethics:
1.
The IFAC Code of Ethics requires
that the accountant performs his or her
professional responsibilities with
competence. A professional accountant
should also take steps to ensure that
those working under his or her authority
in a professional capacity have
appropriate training and supervision.
1.
It was inappropriate for Jones to
hire the two students to conduct the
audit. The examination must be
conducted by persons with proper
education and experience in the field of
auditing. Although a junior assistant
has not completed his formal education,
he may help in the conduct of the
examination as long as there is proper
supervision and review.
2.
The IFAC Code of Ethics requires
that practitioners should be both
independent of mind and in appearance
for audits. Independence is related to
the basic principles of integrity and
objectivity as well as professional
scepticism. Contingent fees for audit
engagements create unacceptable selfinterest and advocacy threats.
2.
To satisfy the IFAC Code, Jones
must be without bias with respect to the
client under audit. Jones has an
obligation for fairness to the owners,
management, and creditors who may
rely on the report. Because of the
financial interest in whether the bank
loan is granted to Boucher, Jones is not
independent in either fact or
appearance with respect to the
assignment undertaken.
3.
The IFAC Code of Ethics requires
that the accountant performs his or her
professional responsibilities with
diligence. Diligent means that the
professional accountant and those
working under his or her authority should
observe technical and professional
standards.
IFAC Code requires Jones to perform
the audit with diligence, which imposes
on Jones and everyone in Jones's
organization a responsibility to observe
the auditing standards.
International Standards on Auditing:
1.
Auditing standards requires that
the engagement partner is satisfied that
the engagement team has the
appropriate capabilities and competence
to perform the audit (ISA 220). The
1.
Jones accepted the engagement
without considering the availability of
competent staff. In addition, Jones
failed to supervise the assistants. The
work performed was not adequately
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engagement partner shall also take
responsibility for direction, supervision
and performance of the audit (ISA 220).
The auditor shall plan the audit so that
the engagement will be performed in an
effective manner (ISA 300).
planned.
2.
The auditor shall obtain an
understanding of internal control relevant
to the audit (ISA 315).
2.
Jones did not study internal
control, nor did the assistants. There
appears to have been no audit
examination at all. The work performed
was more an accounting service than it
was an auditing service.
3.
The auditor shall obtain sufficient
appropriate evidence to be able to draw
reasonable conclusions on which to base
the audit opinion (ISA 500).
3.
Jones acquired little evidence
that would support the fairness of the
financial statements. Jones merely
checked the mathematical accuracy of
the records and summarized the
accounts. Standard audit procedures
and techniques were not performed.
4.
The report shall state that the
audit was conducted in accordance with
the ISAs or relevant national standards
(ISA 700).
4.
Jones’s report made no
reference to the ISAs. Because Jones
did not conduct a proper examination,
the report should state that no opinion
can be expressed as to the fair
presentation of the financial statements
in accordance with the financial
reporting framework.
5.
The report shall state that the
audit includes evaluating the
appropriateness of accounting policies
used and the reasonableness of
accounting estimates made by
management, as well as evaluating the
overall presentation of the financial
statements (ISA 700).
5.
Jones’s improper examination
would not enable her to determine
whether accounting principles have been
consistently applied.
76.
The report shall contain either an
expression of opinion regarding the
financial statements, taken as a whole,
or an assertion to the effect that an
opinion cannot be expressed. When an
overall opinion cannot be expressed, the
reasons therefore should be stated. In
all cases where an auditor's name is
associated with financial statements, the
.
Although the Jones report
contains an expression of opinion, such
opinion is not based on the results of a
proper audit examination. Jones should
disclaim an opinion because she failed to
conduct an examination in accordance
with ISAs.
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report should contain a clear-cut
indication of the character of the
auditor’s work, if any (ISA 700).
2-29
2-15
Circumstance
Type of Opinion
1.
The financial statements are
affected by a departure from the
financial reporting framework.
1.
The auditor should express a
qualified or adverse opinion.
2.
The auditor has a scope
limitation due to a lack of evidence.
2.
The auditor should express a
qualified opinion or disclaim an opinion.
2-16
Item
Number
Type of Audit
Type of Auditor
a.
Operational
Government
b.
Financial statement
External
c.
d.
Compliance or operational
Forensic
Internal or external
Internal, external or forensic
e.
Operational
Government, external, or
internal
f.
Operational
Internal or external
g.
Compliance
Government
h.
Compliance or forensic
Government, external or
forensic
Solutions to Discussion Case
2-17
Part I.
There are arguments both for and against having formal standards for independent auditors
who consult. Advantages include potential increase in public trust, some assurance that a
minimal level of service quality would be attained, and perhaps more guidance for consultants
(to allow them to perform more effective consulting engagements). The primary disadvantage
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would result from the fact that auditors who consult compete with consulting firms comprised of
non-auditors. If standards were not thought out carefully, perhaps the standards would put
auditors at a disadvantage relative to non-auditors in the sense that auditors would be subject to
standards that constrain their activities or perhaps result in their not being able to compete with
non-auditors in the area of fees. Note that Part A of the IFAC Code of Ethics applies to all
professional accountants. (A professional accountant is an individual who is a member of an
IFAC body.) Part B of IFAC Code of Ethics applies to all professional accountants in public
practice. (A professional accountant in public practice is a professional accountant, irrespective
of functional classification (e.g. audit, tax or consulting) in a firm that provides professional
services.) Part B of the Code includes certain restrictions in providing consulting services to
audit clients. These restrictions and IFAC Code of Ethics are covered in a later chapter.
2-18
Part II.
a.
In one sense, E&Y acted unethically. That is, they should have disclosed the nature of
these relationships to MGR. In another sense, it is difficult to ascertain whether these
relationships caused E&Y to act unethically. Specifically, was E&Y’s advice affected by their
relationship with the landlord? Is this relationship the reason that E&Y’s cost-cutting
suggestions did not go farther? These questions point out the importance of independence in
fact and appearance, even when acting in a consulting capacity. Even if E&Y acted ethically,
this relationship creates the appearance of impropriety.
b.
As mentioned in Part a, the relationship with Rouse could have caused E&Y to hesitate
to suggest that the stores for which Rouse was the landlord be closed for fear of losing business
from Rouse. Their relationship with Swidler could have made E&Y feel that they could not lose
the engagement under any circumstances, thereby explaining their apparently lackadaisical
attitude towards the engagement.
Solutions to Internet Assignments
2-19 The IFAC’s homepage contains links to IFAC members via ‘About IFAC’. Members are
typical a national professional organization that has its own homepage, containing information
about the organization, its mission and activities. All IAASB exposure drafts are accessible
using the link ‘Exposure Drafts’. By using the link ‘Standards and Guidance’ IFAC Handbook of
International Auditing, Assurance, and Ethics Pronouncements can be downloaded after
registration. Detailed information about IAASB and the Ethics Committee are found using the
link ‘IFAC Boards and Committees’.
2-20 A search of the homepage of many companies will include links to their latest financial
information. Examining the independent auditor’s report and financial statements will allow the
student have a better idea as to how the chapter’s information is applied in real companies.
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CHAPTER 3
RISK ASSESSMENT AND MATERIALITY
Answers to Review Questions
3-1
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated. Auditor’s business risk is the auditor’s exposure
to loss or injury to professional practice from litigation, adverse publicity, or other events arising
in connection with financial statements audited and reported on. In simple terms, audit risk is
the risk that an auditor will issue an unmodified opinion on materially misstated financial
statements, while auditor’s business risk relates to the auditor's exposure to financial loss and
damage to his or her professional reputation.
3-2
Inherent risk and control risk differ from detection risk in that inherent risk and control
risk exist independently of the audit. The levels of inherent risk and control risk are functions of
the client and its environment, and the auditor has little control over these risks. The auditor can
control detection risk through the scope (nature, timing and extent) of the audit procedures
performed. Thus, detection risk has an inverse relationship with inherent risk and control risk.
3-3
Sampling risk refers to the fact that, in many instances, the auditor does not examine
100 percent of the account balance or class of transactions. Since only a subset of the
population is examined, it is possible that the sample drawn is not representative of the
population and a wrong conclusion may be made on the fairness of the account balance. Nonsampling risk occurs because an auditor may use an inappropriate audit procedure, fail to
detect a misstatement when applying an appropriate audit procedure, or misinterpret an audit
result.
3-4
In understanding of the entity and its environment, the auditor gathers knowledge about:
(1) industry, regulatory, and other external factors; (2) the nature of the entity; (3) its objectives
and strategies, and related business risks; (4) measurement and review of the entity’s financial
performance; (5) internal control.
3-5
Some examples of conditions and events that may indicate the existence of business
risks are:
•
Significant changes in the entity such as large acquisitions, reorganizations or other
unusual events.
•
Significant changes in the industry in which the entity operates.
•
Significant new products or services or significant new lines of business.
•
New locations.
•
Significant changes in the IT environment.
•
Operations in areas with unstable economies.
•
High degree of complex regulation.
3-6
Auditing standards define errors as unintentional misstatements or omissions of
amounts or disclosures in financial statements. Fraud is defined as intentional misstatements
that can be classified into two types: (1) misstatements arising from fraudulent financial
reporting and (2) misstatements arising from misappropriation of assets. Examples of errors
include mistakes in gathering or processing from which financial statements are prepared,
unreasonable accounting estimates arising from oversight or misinterpretation of facts, and
mistakes in the application of accounting principles. Fraud includes intentional manipulation,
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falsification, or alteration of accounting records or supporting documents from which the
financial statements are prepared; misrepresentation in, or intentional omission from, the
financial statements of events, transactions, or other significant information; intentional
misapplication of accounting principles relating to amounts, classification, manner of
presentation, or disclosure; and theft of assets such as cash or inventory.
3-7
The audit risk model has a number of limitations. First, the model assumes that its
components are independent of one another while they are likely to be dependent in the real
world. Second, since the auditor assesses inherent risk and control risk, such assessments
may be higher or lower than the actual inherent risk and control risk that exist for the client.
Third, the model does not separately take into account fraud risk. Last, the audit risk model
does not consider the possibility of non-sampling risk.
3-8
Professional standards provide very little specific guidance on how to assess what is
material to a reasonable user. As a result, auditing firms should develop policies and
procedures to assist their auditors in establishing materiality judgments for clients in order to
minimize the variability of such judgments by firm personnel. In other words, firms would prefer
to have their auditors establish similar materiality judgments for clients with similar
circumstances.
The three major steps in applying materiality are:
3-9
Step 1: Plan a preliminary judgment about materiality. The auditor establishes a preliminary
judgment about materiality by choosing a base, or bases, which is multiplied by a percentage
factor to determine the initial quantitative judgment about materiality. This amount can be
adjusted for qualitative factors that may be relevant for the engagement.
Step 2: Determine tolerable misstatement. This step involves determining tolerable
misstatement based on planning materiality. Tolerable misstatement is the amount of planning
materiality that is allocated to the account balances or classes of transactions so that the auditor
can plan the scope of audit procedures for the individual account balance or class of
transactions.
Step 3: Estimate likely misstatements and compare the totals to the preliminary
judgment about materiality. The auditor estimates likely misstatements and compares the
aggregate misstatements (i.e. likely misstatements and known misstatements) to the preliminary
judgment about materiality. When the aggregate misstatements are less than the preliminary
judgment about materiality, the auditor concludes that the financial statements are fairly
presented. Conversely, when the aggregate misstatements are greater than the planned
judgment about materiality, the auditor should request that the client adjust the financial
statements.
3-10 Total assets or total revenues are better bases for determining materiality for many
entities because these factors are more stable and less variable from year to year than is net
income (profit). Difficulties arise when using net income, or a variant of net income, as a base
when the entity is close to breaking even or experiencing a loss.
3-11 Qualitative factors that may affect the establishment of the preliminary judgment about
materiality (step 1) are shown in Table 3-12. Many of these qualitative factors are cited in ISA
320 ‘Materiality in the Identification and Evaluation of Misstatements’ (exposure draft).
SEC Staff Accounting Bulleting No. 99, “Materiality”
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3-12 Qualitative factors that may affect the establishment of the evaluation of materiality (step
3) are shown in Table 3-12. Many of these qualitative factors are cited in ISA 320 ‘Materiality in
the Identification and Evaluation of Misstatements’ (exposure draft).
Solutions to Problems
3-13
a.
1. is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated
2. Inherent risk is the susceptibility of an assertion to material misstatement, assuming no
related internal controls. Control risk is the risk that material misstatements that could
occur will not be prevented or detected by the internal controls. Detection risk is the risk
that the auditor will not detect a material misstatement that exists in the financial
statements.
3. Inherent risk and control risk differ from detection risk in that they exist independently of
the audit of financial statements, whereas detection risk relates to the auditor's
procedures and can be changed at the auditor's discretion. Detection risk has an
inverse relationship to inherent and control risk.
b.
1.
Omissions or misstatements of items are material if they could, individually or
collectively, influence the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size and nature of the omission or
misstatement judged in the surrounding circumstances. The size or nature of the
item, or a combination of both, could be the determining factor.
2.
Materiality is affected by the nature and amount of an item in relation to the nature
and amount of items in the financial statements under examination, and the auditor's
judgment as influenced by the auditor's perception of the needs of a reasonable
person who will rely on the financial statements. A number of qualitative factors also
affect materiality.
3.
The auditor's judgment about materiality for planning purposes may be different from
materiality for evaluation purposes because the auditor, when planning an audit,
cannot anticipate all of the circumstances that may ultimately influence judgment
about materiality in evaluating the audit findings at the completion of the audit. If
significantly lower materiality levels become appropriate in evaluating the audit
findings, the auditor should reevaluate the sufficiency of the audit procedures already
performed.
3-14
Client No.
Detection Risk
1
25%
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2
10%
3
80%
4
25%
Client No.
Detection Risk
1
Moderate
2
High
3
Low
4
Low
3-15
3-16
1.
2.
3.
4.
5.
B
D
C
B
B
6.
7.
8.
9.
10.
C
D
D
A
D
3-17
a.
Two factors are particularly important in assessing the risk of material misstatement for
Johnson. First, one individual, who also has majority control of the stock, dominates the
decision making in the company. This factor should lead to a higher assessment for the risk of
material misstatement because there is no review of important decisions and actions may be
taken that are not in the best interest of the company or its stockholders. Second, Johnson is
expanding rapidly throughout the southeast. Such expansion may result in material
misstatements since decision making may become decentralized without adequate internal
control. The increase in the risk of material misstatement due to these two factors will result in a
lower determination of detection risk and an increase in the scope of the auditor's work.
b.
A number of the risk factors are present for Close-Moor stores. First, the company is
experiencing a slowdown in sales. Second, there has been turnover in two financial positions
within the company. Third, the president of the company is aggressive and places undue
emphasis on meeting earnings expectations. These factors lead to an increased assessment
for the risk of material misstatement, resulting in a lower assessment of detection risk and more
substantive testing.
c.
The factors affecting the assessment of the risk of material misstatement for MaxiWrite
all relate to industry characteristics. First, the industry is very competitive, which can lead to
price-cutting and its related effects on revenues. Second, the industry is affected by changes in
technology, and MaxiWrite is not one of the industry leaders in technology. Its products usually
are not competitive with the industry leaders in terms of performance. Third, the company is not
as profitable or financially strong as the major companies in the industry. The industry factors
result in an increased assessment of the risk of material misstatement for MaxiWrite, leading to
a lower determination of detection risk and more substantive tests.
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d.
The risk of material misstatement should be increased for the Focus Bank for the
following reasons. First, the audit firm has been the bank's auditors for only two years. Second,
there has been contentious accounting issues related to loan loss reserves and the value of
collateral. Third, prior audits have indicated the presence of misstatements in the loan loss
reserve. Based on these risk factors, detection risk should be set lower and increased
substantive tests performed.
3-18
a.
Pitts has a responsibility to plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatements, whether caused by
error or fraud. If Pitts's risk factor assessment indicates that fraud may be present, she might
respond as follow:
• Increase professional scepticism by questioning and critically assessing audit
evidence.
• Assign more experienced auditors who have the knowledge, skill, and ability
to commensurate with the increased risk of the engagement.
• Consider management's selection and application of significant accounting
policies, particularly those related to revenue recognition, asset valuation, or
capitalizing versus expensing.
• Modify the nature, timing and extent of audit procedures to obtain more
reliable evidence and use increased samples sizes or more extensive
analytical procedures.
Pitts should document the risk of material misstatement for all material accounts and classes of
transactions. The auditor’s documentation includes the following:
• The nature and results of the communication among engagement personnel that
occurred in planning the audit regarding the risks of material misstatement due to fraud.
• The steps performed in obtaining and supporting knowledge about the entity’s business
and its environment. The documentation should include: the risks identified, an
evaluation of management’s response to such risks, and the auditor's assessment of the
risk of fraud after considering the entity’s response.
• The nature, timing, and extent of the procedures performed in response to the risks of
material misstatement due to fraud and the results of that work.
• Fraud risks or other conditions that caused the auditor to believe that additional audit
procedures or other responses were required to address such risks or other conditions.
• The nature of the communications about fraud made to management, those in charge
with governance, and others.
b.
If Pitts had evidence that suggested that fraud might exist, the matter should be brought
to the attention of an appropriate level of management. If the fraud involved senior
management or the fraud causes a material misstatement of the financial statements, Pitts
should report it directly to those in charge with governance ( e.g. the board of directors or the
audit committee). In addition, Pitts should reach an understanding with those in charge with
governance regarding the expected nature and extent of communications about
misappropriations perpetrated by lower-level employees.
Pitts has no responsibility to disclose the fraud to parties other than the client's senior
management and those in charge with governance because of ethical or legal obligations of
confidentiality. However, the auditor’s legal responsibilities vary by country and in certain
circumstances the duty of confidentiality may be overridden by statute, the law or courts of law.
The IFAC Code of Ethics for Professional Accountants provides guidance on circumstances
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where auditors should disclose confidential information or when such disclosure may be
appropriate. (Chapter 19 discusses the IFAC Code of Ethics.)
To a funding agency or other specified agency in accordance with requirements for the audits of
entities that receive governmental financial assistance.
3-19
Client No.
1
2
3
4
PJM (rounded)
$€54,800
$3€10,000
$€2,835,000
$€38,700,000
Solution to Discussion Cases
3-20
a.
Materiality and audit risk both would likely be set at very low levels. Investors and
creditors to assess their investments in light of MGR’s difficulties probably will use the financial
statements quite extensively. In addition, the auditors likely would set audit risk quite low
because there is a high risk of litigation against the auditor should MGR declare bankruptcy.
The auditor would set audit risk low to minimize the risk of rendering an inappropriate audit
opinion.
b.
Inventory is the account that most likely is misstated. Inventory already has been written
down, and MGR’s trouble generating sales suggests that further inventory write-downs are
likely. This explanation represents an inherent risk factor because it involves business factors
that affect valuation. There also are motivations to overvalue inventory (to inflate financial
position), which also represents an inherent risk factor.
c.
MGR’s motivations to misstate its financial position to mask its difficulties certainly create
a motivation to commit fraud; this represents a high likelihood of fraudulent financial reporting.
Misappropriation of assets (theft) also is a possibility because MGR’s inventory likely is
attractive to its employees. However, fraudulent financial reporting would be of greater concern
to the auditors.
d.
Auditor’s business risk would be very high because of the likelihood that the client will go
out of business as well as the likelihood that the client will commit fraud.
e.
The entity’s business risk also is high because of its continuing financial difficulties.
3-21
a. First, it is important to understand that the fraud at Cendant involved fraudulent financial
reporting as opposed to misappropriation of assets. All three aspects of the fraud
triangle are present in this situation. Incentives include pressure to meet analysts’
expectations. A weak control system, a lax auditor, and the presence of many
accounting estimates present opportunities for fraud. Rationalization is created by an
‘everybody does it’ attitude and a weak commitment by management to accurate
financial reporting.
b. Signals that fraud may have been occurring include the fact that Cendant always met
analysts’ expectations, top management implemented inadequate controls, the growth of
large favourable adjustments, constant revisions of reserves, and inadequate
justification for the large transfer from a reserve.
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Solutions to Internet Assignments
3-22
a.
Jones would use the total assets of €29,611,000 as the base in Exhibit 3-4. Using this
amount, the preliminary judgment of materiality is €176,000 (rounded). This amount is
determined by using the planning materiality of €85,500 (the amount over €10 million but not
over €30 million) and adding €90,400 to it. The €90,400 was determined by using the excess
over €10 million and multiplying it by .00461 (€19.611 million x .00461).
b.
There are a number of sites on the Internet that contain information on the paging
(telecommunications) industry. Unfortunately, many of these sites sell their data at relatively
high prices. Two sites that contained such information are: Info Edge (www.info-edge.com),
and The Strategis Group (www.strategisgroup.com). The Personal Communications Industry
Association (PCIA) (www.pcia.com) and the Canadian Wireless Telecommunications
Association (CWTA) (www.cwta.ca) have homepages that contain information on the industry.
Another source of information is the homepages of other companies that operate in the paging
industry.
c.
The memo describing Calabro Paging Services’ client business risk should include the
following factors:
• Highly competitive industry, with price being the primary means of
differentiation among service providers.
• There are many licensed companies with the industry undergoing
consolidation through merger and acquisition.
• The industry requires substantial funds to finance the maintenance and growth
of operations and customer base.
• Many smaller companies in the industry are losing money.
• There are significant risks to changing technology.
• Many of Calabro’s competitors are larger and better financed.
• The industry is subject to regulation.
3-23 The answers to this Internet assignment will be a function of the company assigned by
the instructor. However, the responses to the questions will be found in the sources cited in the
problem and will be similar to those in the questionnaire provided by your instructor or
downloaded from the book’s website. For example, we have used companies in the
pharmaceutical industry for this assignment.
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CHAPTER 4
AUDIT EVIDENCE AND AUDIT DOCUMENTATION
Answers to Review Questions
4-1
Auditors typically divide the financial statements into components or segments in order
to make the audit more manageable. A component can be a financial statement account or a
transaction process. This approach allows the auditor to gather evidence by examining the
processing of related transactions through the accounting system from their origin to their
ultimate disposition in the accounting journals and ledgers. Thus, the auditor can examine an
accounting transaction from the time it is initiated by the entity until its final recording in the
financial statement accounts.
4-2
There is a top-down relationship from the financial statements to the audit procedures.
The financial statements contain management's assertions about the various financial
statement components. The auditor tests each relevant management assertion and then
conducts audit procedures to gather evidence to test whether the assertions are being met. The
results from applying audit procedures provide the evidence that supports the fair presentation
of management’s assertions and the auditor's report (see Figure 4-1).
4-3
Assertions about classes of transactions and events for the period under audit:
Assertion
Definition
Occurrence
Transactions and events that have been recorded have
occurred and pertain to the entity (sometime referred to as
validity).
Completeness
All transactions and events that should have been recorded
have been recorded.
Authorization
All transactions and events have been properly authorized.
Accuracy
Amounts and other data relating to recorded transactions and
events have been recorded appropriately.
Cutoff
Transactions and events have been recorded in the correct
accounting period.
Classification
Transactions and events have been recorded in the proper
accounts.
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4-4
Assertions about account balances at the period end:
Assertion
Definition
Existence
Assets, liabilities, and equity interests exist.
Rights and
The entity holds or controls the rights to assets, and liabilities
Obligations
are the obligations of the entity.
Completeness
All assets, liabilities and equity interests that should have
been recorded have been recorded.
Valuation and
Assets, liabilities, and equity interests are included in the
Allocation
financial statements at appropriate amounts, and any
resulting valuation or allocation adjustments are appropriately
recorded.
4-5
Audit evidence is all the information used by the auditor in arriving at the conclusions on
which the audit opinion is based, and includes the information contained in the accounting
records underlying the financial statements and other information. Corroborating or other
evidence includes both written and electronic information such as cheques, records of electronic
transfers, invoices, contracts, minutes, confirmations, and written representations. It also
includes information obtained by the auditor through inquiry, observation, inspection, and
physical examination.
4-6
Audit evidence is usually persuasive rather than convincing for two reasons. First, since
an audit must be completed in a reasonable amount of time and at a reasonable cost, the
auditor examines only a sample of the transactions that compose the class of transactions or
account balance. Second, due to the nature of evidence, auditors must often rely on evidence
that is not perfectly reliable. The types of audit evidence examined by the auditor have different
degrees of reliability, and even highly reliable evidence has weaknesses. Therefore, the
evidence obtained by the auditor seldom provides absolutely convincing about an audit
objective.
4-7
The types of audit procedures and their definitions are: (1) Inspection of records or
documents consists of examining internal and external records or documents that are in paper
form, electronic form, or other media. (2) Inspection of physical assets consists of physical
examination of assets. (3) Reperformance is the auditor's independent execution of
procedures or controls that were originally performed as part of the entity’s internal control,
either manually or through the use of CAATs. (4) Recalculation consists of checking the
mathematical accuracy of documents and records. (5) Scanning is the review of accounting
data to identify significant or unusual items. (6) Inquiry consists of seeking information of
knowledgeable persons, both financial and non-financial, throughout the entity and outside the
entity. (7) Observation consists of looking at a process or procedure being performed by
others. (8) Confirmation is the process of obtaining a representation of information or of an
existing condition directly from a third party. (9) Analytical procedures consist of evaluations
of financial information made by a study of plausible relationships among both financial and
non-financial data (ISA 520).
4-8
Vouching refers to first selecting an item for testing from the accounting journals or
ledgers and then examining the underlying source document. Thus, the direction of testing is
from the journals or ledgers back to the source documents. Vouching provides evidence that
items included in the accounting journals or ledgers have occurred (are valid). Tracing refers to
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first selecting an accounting transaction (a source document) and then following it into the
journal or ledger. The direction of testing in this case is from the source documents to the
journals or ledgers and tests whether transactions that occurred are recorded (completeness) in
the accounting records.
4-9
Corroborating evidence is obtained for inquiry and for observation because these audit
procedures typically are not from independent sources and therefore are not considered to be
highly reliable. For example, the auditor might follow up the client's responses concerning the
internal controls over the raw-material storeroom by conducting tests of the control procedures
to verify their existence and effectiveness.
4-10 Inspection of tangible assets, reperformance, and recalculation are generally considered
of high reliability because the auditor has direct knowledge about them. Inspection of records
and documents, scanning, confirmation, and analytical procedures are generally considered to
be of medium reliability. The reliability of inspection of records and documents depends
primarily on whether a document is internal or external. Scanning depends on the auditor’s
ability to identify anomalous items using judgment or CAATs. The reliability of confirmations is
affected by the form of the confirmation, prior experience with the entity, the nature of the
information being confirmed, and the intended respondent. The reliability of analytical
procedures may be affected by the quality of the client's internal control system. Finally, inquiry
and observation are generally low-reliability types of evidence since both require further
corroboration by the auditor.
It should be understood, however, that levels of reliability for the types of evidence should be
considered as general guidelines. The reliability of the types of evidence may vary considerably
across entities, and it is subject to a number of exceptions.
4-11
It is important that the audit documentation or working papers be organized or indexed in such a
way that members of the audit team or firm can find relevant audit evidence. When the auditor
performs audit work on one working paper and supporting information is obtained from another
working paper, the auditor cross-references the information on each working paper. This
process of indexing and cross-referencing provides a trail from the financial statements to the
individual working papers that can be easily followed members of the audit team or firm. Today,
much of this cross-referencing is facilitated by the use of electronic working paper programs.
Solutions to Problems
4-12
a.
b.
c.
d.
e.
5
4
1
2
3
4-13
a.
b.
c.
d.
e.
f.
8
1
3
6
9
2
g.
h.
i.
j.
k.
7
3
8
1/3
5
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4-14
a.
b.
c.
d.
e.
f.
g.
h.
i.
Category of Assertion
Assertions about account balances
Assertions about transactions and events
Assertions about account balances
Assertions about account balances
Assertions about account balances
Assertions about account balances
Assertions about account balances
Assertions about account balances
Assertions about account balances
j.
k.
Assertions about transactions and events
Assertions about account balances
Assertion
existence
cutoff
completeness
valuation and allocation
valuation and allocation
existence
completeness/existence
valuation and allocation
Valuation and allocation/
completeness
accuracy
valuation and allocation
4-15
a.
The audit plan converts the overall audit strategy into a more detailed plan and contains
the planned audit procedures. It serves as an outline of the evidence-gathering procedures that
the auditor will follow during the audit. An audit plan serves as a record of the work performed
during the audit. It represents evidence that the audit was conducted in accordance with
auditing standards. Since an audit plan typically includes specific steps to gain corroborative
evidence, it serves as a list of procedures necessary to test actual transactions and resulting
balances.
b.
Examples of the types of audit procedures that would be used by the auditor during an
audit of financial statements are the following (note that each procedure listed relates to one of
the types of procedures listed in the chapter):
• Observation of activities and conditions.
• Physical examination and counts.
• Confirmation.
• Inspection of authoritative documents.
• Recalculation.
• Tracing or Retracing (e.g., tracing bookkeeping procedures, walking through the system,
checking data processing flow, agreeing evidence to accounting records, flow-charting,
checking audit trail, vouching, etc.).
• Scanning.
• Inquiry of client personnel and management.
• Examination and corroboration of subsidiary records.
• Analytical procedures.
• Review of documents relating to subsequent events (including cutoff examination of
cash receipts and disbursements in subsequent events period).
• Requesting confirmation of information from outside experts.
• Examination of legal letters.
4-16
a.
The bank confirmation would be considered more reliable than the observation of
segregation of duties because an independent external party provided the information.
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Observation is not as reliable because the individuals performing the functions may act
differently when someone is observing them.
b.
The auditor's recalculation of depreciation is more reliable than the examination of the
raw material requisitions because the auditor has direct personal knowledge of the outcome.
c.
The bank statement would be considered more reliable than shipping documents
because the bank statement was prepared by an entity that is external to the client.
d.
The physical examination of the common stock certificates would generally be
considered more reliable than a physical examination of inventory components for a personal
computer because the stock certificates are prepared by an entity external to the client.
Additionally, the auditor may not be able to easily determine the quality or value of the computer
components.
4-17
a. Type
b. Reliability
1. Internal
1.
High if internal control is excellent, moderate to low otherwise.
2. Internal
2.
High if internal control is excellent, moderate to low otherwise.
3. External
3.
High because it comes from an external party.
4. External
4.
High to moderate because the document has been circulated to a
party outside the entity.
5. External
5.
High because it comes from an external party.
6. Internal
6.
High if internal control is excellent, moderate to low otherwise.
7. Internal
7.
High if internal control is excellent, moderate to low otherwise.
8. Internal
8.
High if internal control is excellent, moderate to low otherwise.
9. External
9.
High to moderate because the document has been circulated to a
party outside the entity.
10.External
10.
High because it comes from an external party.
4-18
a.
The reliability of evidence obtained through confirmations is directly affected by factors
such as:
• The form of the confirmation.
• Prior experience with the entity.
• The nature of the information being confirmed.
• The intended respondent.
There are two types of confirmation requests: the positive form and the negative form. Positive
confirmations are generally considered more reliable because the respondent must reply to the
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requested information. A non-response to a negative confirmation is assumed to be correct.
Prior experience with the client in terms of confirmation response rates, misstatements
identified, and the accuracy of returned confirmations should be considered when assessing the
reliability of confirmations. If response rates were low in prior audits, the auditor might consider
obtaining evidence using alternative procedures. The nature and availability of the information
being confirmed may directly affect the appropriateness of the evidence obtained. The intended
respondent to confirmations may vary from individuals with little accounting knowledge to highly
qualified accounting personnel in large companies. The auditor should consider the
respondent's competence, knowledge, ability, and objectivity when assessing the reliability of
confirmation requests.
b.
The following amounts or information included in EarthWear’s financial statements could
be confirmed. The source of the confirmation is also included.
Amounts or Information Confirmed
Source of Confirmation
Cash balances
Banks
Accounts receivable
Individual customers
Lines of credit
Banks
Accounts payable
Individual vendors
Lease assets
Leaseholders
Common stock outstanding
Registrar/Transfer agent
Insurance coverage
Insurance company
4-19
a.
Auditing standards (ISA 230), stipulates that audit documentation (working papers)
should: (1) provide a record of the basis for the auditor’s report and (2) provide evidence that
the audit was performed in accordance with auditing standards and applicable legal and
regulatory requirements.
b.
The more common types of working papers include the overall audit strategy and audit
plan, working trial balance, adjusting and reclassification entries, account analysis and listings,
and audit memoranda.
c.
Factors affecting the auditor's judgment about the nature and extent of audit
documentation include (1) matters that give rise to significant risks; (2) results of audit
procedures indicating that the financial information could be materially misstated, or a need to
revise the auditor’s previous assessment of the risks of material misstatement and the auditor’s
responses to those risks; (3) circumstances that cause the auditor significant difficulty in
applying necessary audit procedures; (4) findings that could result in a modification of the
auditor’s opinion (ISA 230).
Solution to Discussion Case
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4-20
Part I
a.
Because of the large increase in sales, both in general and abroad, the auditor
primarily would be concerned with occurrence of sales transactions.
b.
For the same reason given in part a, the auditor would be concerned with the
existence of the accounts receivable. In addition, because there is some evidence
that the increase in accounts receivable seemed to be greater than the increase in
sales (e.g., greater percentage increase in accounts receivable than for sales,
increase in average days outstanding), the auditor also would be concerned with
valuation or allocation (i.e. to what extent are the receivables collectible).
c.
The auditor could vouch sales and receivables. Specifically, to examine the
occurrence and existence assertions, auditors could choose a sample sales
transactions and examine supporting documents, perhaps paying particular attention
to the existence of a valid sales order as well as evidence that the products were
shipped (i.e. shipping documents).
The auditor also could confirm a sample of accounts receivable with customers, perhaps asking
the customers to fill in the monetary amount that they owe as of the balance sheet date. This
procedure would help verify existence or occurrence, rights and obligations, and valuation or
allocation.
The auditor also could prepare an aging schedule to check for the existence of a significant
amount of old receivables. This procedure would be useful primarily for valuation or allocation.
Part II
a.
The auditors could have examined documentation for sales transactions, particularly
searching for valid sales orders and evidence that the products sold were shipped.
The auditor also could have considered sending additional confirmations to a larger
number of customers, perhaps asking the customer to fill in the dollar amounts
because there is so much doubt about the accuracy of L&H’s figures.
b.
The confirmation responses suggest that management integrity likely is low,
especially those that stated they were not a customer of L&H’s. Therefore, the
auditor would be unlikely to use inquiry of the client as an audit procedure.
4-21
a.
The auditor can assess the reliability of the client's records for developing the allowance
for return of unsold books by testing the number of books sold and the number of books
returned. Taking a sample of sales by individual title and tracing them into the client’s internal
records could accomplish this. This would verify the sales portion of the internal records. The
book return portion of the client’s records can be tested by examining a sample of receiving
documents used to record the books returned by individual titles from the retail stores. If these
tests indicated that the client's records were accurate, the auditor could rely on the client's
records for establishing the allowance for return of unsold books.
b.
The return rate could be estimated for relatively new titles in a number of ways. One
possibility is to use the average historical ‘first-year’ return rate for all new titles. Another
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possibility is to estimate the first-year return rate by individual author. Thus, if a new title was
from an author who had previously published with Bentley Bros., the author's average first-year
rate could be tested and used.
c.
Other than average industry data, there is not likely to be much external evidence that
can be gathered on returned books. It might be possible to send a confirmation to the major
retail stores and ask for information on current sales activity. Some evidence might also be
gathered from the ‘best-selling’ book lists.
Solution to Internet Assignment
4-22 A general search for each term using an Internet browser resulted in a long list of ’hits;’
most of which did not apply to the material covered in the text. One site
(www.accountingstudents.com) provided a glossary of auditing terms that contained EDI and
image processing systems. The Institute of Internal Auditors' home page (www.theiia.org)
contained some information related to EDI and image processing systems. EDI refers to the
electronic exchange of data, for example, the electronic exchange of data regarding inventory
requirements between a customer and a vendor. Image processing systems capture and store
electronic images, usually reproductions of documents. For example, many banks now make
electronic images of cancelled cheques available to their customers online. These technologies
have fundamental implications for auditing, especially in terms of the quality of the electronic
evidence involved in both. If important audit evidence is stored only in electronic form and
controls over the integrity of the electronic records are not adequate, the auditor may not be
able to gather sufficient appropriate evidence to express an unmodified opinion on the client’s
financial statements.
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CHAPTER 5
AUDIT PLANNING AND TYPES OF AUDIT TESTS
Answers to Review Questions
5-1
The auditor should inquire of the prospective client’s bankers and lawyers, credit
agencies, and other members of the business community who may have knowledge about the
integrity of the prospective client and its management.
5-2
The legal and regulatory responsibilities for communication between the successor and
predecessor auditor differ among countries. Auditing standards (ISA 300) requires that the
successor auditor communicates with the predecessor auditor, in compliance with relevant legal
and ethical responsibilities. Subject to any legal constraints the successor auditor is responsible
for initiating the communication with the predecessor auditor. However, the successor auditor
should request permission of the prospective client before contacting the predecessor auditor.
The successor auditor’s communication with the predecessor auditor should include questions
related to the integrity of management, disagreements with management over accounting and
auditing issues, and the predecessor auditor’s understanding of the change in auditors.
5-3
An engagement letter is used to formalize the arrangement reached between the auditor
and client. It serves as a contract that outlines the responsibilities of both parties and is
intended to prevent misunderstandings between the two parties. The letter states the
responsibilities of the auditor and management, that the audit will be conducted in accordance
with auditing standards, that certain types of audit procedures will be conducted and written
representations will be obtained from management, and that the audit may not detect all
material errors and fraud. Exhibit 5-1 in the text contains a sample engagement letter. In
addition, the engagement letter might include:
Arrangements involving the use of experts or internal auditors.
laws and other regulations may restrict or prohibit such liability limiting arrangements.)
Additional services to be provided relating to regulatory requirements.
Arrangements regarding other services (e.g. assurance, tax or consulting services).
The following factors can be used to judge the competence of the internal auditors:
5-4
5-5
Educational level and professional experience.
Professional certification and continuing education.
Audit policies, procedures, and checklists.
Practices regarding their assignments.
The supervision and review of their audit activities.
The quality of their working paper documentation, reports, and recommendations.
Evaluation of their performance.
The objectivity of the internal auditors can be determined by assessing the following factors:
The organizational status of the internal auditor responsible for the internal audit
function.
Policies to maintain internal auditors’ objectivity about the areas audited.
5-5
Those charged with governance is defined as the person(s) with responsibility for
overseeing the strategic direction of the entity and obligations related to the accountability of
the entity. This includes overseeing the financial reporting and disclosure process. The
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structures of corporate governance vary from country to country. Thus, the supervisory,
board of directors and/or audit committee may be the focus. Note that in an increasing
number of countries audit committees are mandatory requirements for listed companies.
Companies also establish audit committees on voluntary basis. The audit committee may
be directly responsible for the appointment, compensation, and oversight of the work of any
audit firm employed by the company. Further, all audit and non-audit services provided by
its auditor may require pre-approval by the audit committee.
The overall audit strategy sets the scope, timing, and direction of the audit. In
developing the overall audit strategy, the auditor considers the results of the other
planning steps (i.e. assessment of a preliminary level for control risk by account and
assertion, considerations of the possibility of non-compliance with laws and regulations,
identification of related parties, and performance of preliminary analytical procedures)
and the results of the risk assessment procedures performed to gain an understanding
of the entity (including client’s business objectives and strategies, business risks, audit
risks, and risk management). The auditor finalizes the overall audit strategy by
documenting the effects of the identified risks and controls on the planned audit
procedures.
5-6
Develop an overall audit strategy and prepare audit programs.
Circumstances that may indicate a possible illegal act include the following:
Unauthorized transactions, improperly recorded transactions, or transactions not
recorded in a complete or timely manner.
Investigation by a government department, enforcement proceeding, or payment of
unusual fines or penalties.
Violations of laws or regulations cited in reports of examinations by regulatory
authorities.
Large payments for unspecified services to consultants, affiliates, or employees.
Sales commissions or agents' fees that appear excessive.
Large payments in cash or bank cashiers’ cheques.
Unexplained payments to government officials.
Failure to file tax returns or pay government duties.
•
•
•
•
•
•
•
•
5-8
The auditor can identify related parties by (1) evaluating the client’s procedures for
identifying related parties, and (2) requesting a list of related parties from management. Some
additional audit procedures that may identify transactions with related parties include:
• Review significant contracts and agreements not in the ordinary course of business,
including those involving management and those charged with governance.
• Review bank and legal confirmations.
• Review invoices and correspondence from law firms.
• Review minutes of meetings of shareholders, management, and those charged with
governance.
• Review the entity’s income tax returns.
• Perform auditor procedures designed to identify significant and unusual transactions and
determine whether related parties are involved.
5-9
The three general types of audit tests are risk assessment procedures, tests of controls
and substantive tests. Risk assessment procedures are used by the auditor to obtain an
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understanding of the entity and its environment, including internal control. Examples include
inquiries of management and others, analytical procedures, and observation and inspection.
obtaining audit evidence about the operating effectiveness of controls in preventing, or detecting
and correcting, material misstatements at the assertion level. Examples of tests of controls
include inquiries of appropriate client personnel, inspection of documents and reports,
observation of the application of a specific internal control, and reperformance of the application
of the control by the auditor.
Substantive tests are performed to detect material misstatements (i.e. monetary errors) in an
account balance, transaction classes, and disclosure components of the financial statements.
Examples of substantive tests are substantive tests of transactions, analytical procedures, and
tests of account balances.
5-10 The purposes for using analytical procedures at the planning stage of an audit are (1) to
enhance the auditor’s understanding of the client’s business and the transactions and events
that have occurred since the last audit and (2) to identify areas that may represent risks relevant
to the audit.
5-11 The quality of an expectation is referred to as the precision of the expectation. Precision
is a measure of the potential effectiveness of an analytical procedure; it represents the degree
of reliance that can be placed on the procedure. Precision is a measure of how closely the
expectation approximates the unknown ‘correct’ amount. The degree of desired precision will
differ with the specific purpose of the analytical procedure. The precision of the expectation is a
function of the materiality and required detection risk for the assertion being tested. If the
assertion being tested requires a low level of detection risk, the expectation needs to be very
precise. However, the more precise the expectation, the more extensive and expensive are the
audit procedures used to develop the expectation, resulting in a cost/benefit trade-off.
The second step in the substantive analytical procedures decision process is to define or
calculate a tolerable difference. Since the expectation developed by the auditor will rarely be
identical to the client's recorded amount, the auditor must decide the amount of difference that
would require further investigation. The size of the tolerable difference depends on the
significance of the account, the desired degree of reliance on the analytical procedure, the level
of disaggregation in the amount being tested, and the precision of the expectation. Auditors
often use rules of thumb such as, ‘tolerable difference is 10% of the predicted amount and/or a
difference less than €75,000.’
5-12 Explanations for significant differences observed for substantive analytical procedures
must be followed up and resolved through quantification, corroboration, and evaluation.
Quantification: Quantification involves determining whether the explanation or error can
explain the observed difference. This may require the recalculation of the expectation after
considering the additional information. For example, a client may offer the explanation that the
inventory account increased by a certain percentage as compared to the prior year due to a 12
percent increase in raw materials prices. The auditor should compute the effects of the raw
materials price increase and determine the extent to which the price increase explains (or does
not explain) the increase in the inventory account.
Corroboration: Auditors must corroborate explanations for unexpected differences by obtaining
sufficient appropriate audit evidence linking the explanation to the difference and substantiating
that the information supporting the explanation is reliable. This evidence should be of the same
quality as the evidence obtained to support tests of details. Common corroborating procedures
include examination of supporting evidence, inquiries of independent persons, and evaluating
evidence obtained from other auditing procedures.
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Evaluation: Evaluation involves the effective use of professional scepticism, combined with the
desire to obtain sufficient appropriate audit evidence, similar to other auditing procedures. The
auditor should evaluate the results of the substantive analytical procedures to conclude whether
the desired level of assurance has been achieved. If the auditor obtains evidence that a
misstatement exists and can be sufficiently quantified, the auditor makes note of his or her
proposed adjustment to the client’s financial statements.
5-13 The Audit Testing Hierarchy starts with tests of controls and substantive analytical
procedures because they are generally both more effective and more efficient than starting with
tests of details (i.e. substantive tests of transactions and substantive tests of account balances
and disclosures).
5-14 Some of the buckets are larger than others because certain assertions will be more
important or present bigger risks for some accounts than for others. For instance, existence (or
validity) is typically more important for accounts receivable than it is for accounts payable. After
the auditor has determined the risks associated with the assertions for an account balance, she
can determine the size of the assurance buckets (i.e. how much assurance is needed) and then
begin filling the buckets by applying the audit testing hierarchy.
5-15 There are four categories of financial ratios discussed in the text: short-term liquidity
ratios, activity ratios, profitability ratios, and coverage ratios. Short-term liquidity ratios are
indicators of the entity’s ability to meet its current obligations when they become due. Activity
ratios indicate how effectively the entity's assets are managed. Profitability ratios are indicators
of the entity’s success or failure for a given period. Coverage ratios provide information on the
long-term solvency of the entity, including the ability of the entity to continue as a going concern.
Solutions to Problems
5-16
a.
The procedures (if not restricted by law) Hall should perform before accepting the
engagement include the following:
1.
Hall should explain to Adams the need to make an inquiry of Dodd and should request
permission to do so.
2.
Hall should ask Adams to authorize Dodd to respond fully to Hall’s inquiries.
3.
If Adams refuses to permit Dodd to respond or limits Dodd’s response, Hall should
inquire as to the reasons and consider the implications in deciding whether to accept the
engagement.
4.
Hall should make specific and reasonable inquiries of Dodd regarding matters Hall
believes will assist in determining whether to accept the engagement, including specific
questions regarding:
• Facts that might bear on the integrity of management.
•
Disagreements with management as to accounting principles, auditing
procedures, or other similarly significant matters.
• Dodd's Dodd’s understanding as to the reasons for the change of auditors.
5.
If Hall receives a limited response, Hall should consider its implications in deciding
whether to accept the engagement.
b.
The additional procedures Hall should consider performing during the planning phase of
this audit that would not be performed during the audit of a continuing client may include the
following:
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1.
Hall may apply appropriate auditing procedures to the account balances at the beginning
of the audit period and, possibly, to transactions in prior periods.
2.
Hall may make specific inquiries of Dodd regarding matters Hall believes may affect the
conduct of the audit, such as
• Audit areas that have required an inordinate amount of time.
• Audit problems that arose from the condition of the accounting system and records.
3.
Hall may request Adams to authorize Dodd to allow a review of Dodd’s working papers.
4.
Hall should document compliance with firm policy regarding acceptance of a new client.
5.
Hall should start obtaining the documentation needed to create a permanent working
paper file.
5-17
a.
Prior to acceptance of the engagement, Tish & Field should have communicated with the
predecessor auditor regarding:
• Facts that might bear on the integrity of management.
• Disagreements with management concerning accounting principles, auditing
procedures, or other significant matters.
• The predecessor’s understanding about the reason for the change.
• Any other information that may be of assistance in determining whether to accept the
engagement.
b.
The form and content of engagement letters may vary, but they would generally contain
information regarding:
• The objective of the audit.
• The estimated completion date.
• Management's Management’s responsibility for the financial statements.
• The scope of the audit.
• Other communication of the results of the engagement.
• The fact that because of the test nature and other inherent limitations of an audit,
together with the inherent limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may remain undiscovered.
• Access to whatever records, documentation, and other information may be requested in
connection with the audit.
• Arrangements with respect to client assistance in the performance of the audit
engagement.
• Expectation of receiving from management written confirmation concerning
representations made in connection with the audit.
• Notification of any changes in the original arrangements that might be necessitated by
unknown or unforeseen factors.
• A request for the client to confirm the terms of the engagement by acknowledging receipt
of the engagement letter.
• The basis on which fees are computed and any billing arrangements.
Additional procedures to be performed prior to the beginning of field work are:
Reading the current year’s interim financial statements.
Discussing the scope of the examination with management of the client.
Establishing the timing of the audit work.
Arranging with the client for adequate working space.
Coordinating the assistance of client personnel in data preparation.
Establishing and coordinating staffing requirements, including time budget.
5-18
5.
6.
7.
8.
9.
10.
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11.
Holding a planning conference with assistants assigned to the engagement and discuss
possible fraud-related issues.
12.
Determining the extent of involvement, if any, of consultants, experts, and internal
auditors.
13.
Considering the effects of applicable accounting and auditing pronouncements,
particularly recent ones.
14.
Considering the need for an appropriate engagement letter.
15.
Preparing documentation setting forth the preliminary audit plan.
16.
Making a preliminary judgment about materiality.
17.
Making a preliminary judgment about control risk.
18.
Updating the prior year's written audit plan.
5-19
a.
The typical engagement letter generally includes the following:
1. The name and address of the person or persons who retained the auditor to perform the
auditing services.
2. An opening paragraph that confirms the understandings of the auditor and the client.
3. A summary of significant events that led to the retention of the services of the auditor.
4. A general description of the audit firm that will conduct the examination.
5. A statement that the examination will be performed in accordance with relevant auditing
standards.
6. A description of the scope of the services to be rendered, which should establish the
nature of the engagement.
7. Any scope restrictions or special limitations and their effect on the auditor's report.
8. A statement regarding the auditor’s responsibility for the detection of fraud.
9. An indication of the possible use of client personnel in connection with the audit work to
be performed.
10. A statement that the auditor will provide a management letter if required in the
circumstances.
11. The form of any report or other communication of the engagement.
12. The method and timing of billings as well as billing rates and fee arrangements.
13. Space for the client representative’s signature, which indicates acceptance of the letter
and the understandings therein.
b.
The benefits of preparing an engagement letter include the avoidance of possible
problems between the independent auditor and the client concerning (1) the scope of the work,
(2) the service to be rendered, and (3) the audit fee. In addition, the ‘in-charge’ auditor
conducting the examination can avoid misunderstanding the nature and scope of the
engagement if the engagement letter is included in the permanent section of the audit working
papers. The letter should eliminate misunderstandings and confusion about the type of financial
statements to be examined, the estimated report date, and the type of opinion expected. In
addition to avoiding possible misunderstandings, any legal problems relating to the auditor's
failure to perform certain procedures can be reviewed with reference to the contractual
commitment assumed. For example, if scope limitations prevent the auditor from performing
normal audit procedures, the auditor cannot be legally responsible if a fraud is not detected
when clearly it would have been detected if such procedures were performed. The engagement
letter is also useful as a reference document when preparing for future engagements.
5-20 a.
An audit committee is an important part of a company’s organizational structure.
It is ordinarily a special committee formed by the board of directors. It is typically a group of
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outside directors who have no active day-to-day operational role and who are a liaison between
the independent auditor and the board of directors. The audit committee assists and advises
the full board of directors and in doing so aids the board in fulfilling its responsibility for financial
reporting.
b.
Audit committees are formed to satisfy the shareholders’ need for assurance that
directors are exercising due care in the performance of their duties. For listed companies they
are often mandated. Audit committees may also be formed on voluntary basis so that a
company can be more responsive to the needs of those interested in financial reporting. Their
formation itself is recognition of the responsibilities of both the entity and its auditor to investors
and creditors. Also, they may be formed to reinforce auditor’s independence, particularly the
appearance of independence, from the management of a company whose financial statements
are being examined by the auditor.
c.
The functions of an audit committee may include the following:
Selection of the independent auditor, discussion of audit fee with the auditor, and review
of the auditor’s engagement letter.
Review of the independent auditor’s overall audit plan (scope, purpose, and general
audit procedures).
Review of the annual financial statements before submission to the full board of directors
for approval.
Review of the results of the auditor’s examination including experiences, restrictions,
cooperation received, findings, and recommendations. Matters that the auditor believes
should be brought to the attention of the directors or shareholders should be considered.
Review of the independent auditor’s evaluation of the company’s internal control
systems.
Review of the company’s accounting, financial, and operating controls.
Review of the reports of internal audit staff.
Review of interim financial reports to shareholders before the board of directors
approves them.
Review of company policies concerning contributions to external parties (e.g. political
parties), conflicts of interest, and compliance with laws and regulations, and investigation
of compliance with those policies.
Review of financial statements that are part of prospectuses or offering circulars; review
of reports before they are submitted to regulatory authorities.
Review of the independent auditor’s observations of financial and accounting personnel.
Participation in the selection and establishment of accounting policies; review the
accounting for specific items or transactions as well as alternative accounting treatments
and their effects.
Review of the impact of new or proposed pronouncements by the accounting profession
or regulatory authorities.
Review of the company’s insurance program.
Review and discussion of the independent auditor’s management letter.
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
5-21
a.
If Post discovers that General’s financial statements may be materially misstated due to
fraud, Post should consider the implications for other aspects of the audit and discuss the
matter and approach to further investigation with an appropriate level of management and those
charged with governance. Post should also attempt to obtain sufficient appropriate evidence to
determine whether, in fact, material fraud exist and, if so, its effect. Post may suggest that
General consult with its legal counsel on matters concerning questions of law.
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b.
If Post is precluded from applying necessary procedures, Post should disclaim or qualify
an opinion on the financial statements and communicate these findings to General’s audit
committee or its board of directors.
c.
If Post concludes that General’s financial statements are materially affected by fraud,
Post should insist that the financial statements be revised and, if they are not, express a
qualified or an adverse opinion on the financial statements, disclosing all the substantive
reasons for such an opinion. Additionally, Post should adequately inform General’s audit
committee or its board of directors about the fraud.
d.
Post may have a duty to disclose fraud to third parties outside General’s management
and its audit committee, e.g. to supervisory authorities. Legal duties to report fraud to third
parties vary by country.
5-22
5-23
a.
•
Audit Procedure
Assertion
1
Accuracy
2
Existence
3
Cutoff
4
Valuation and allocation
Analytical procedures are used for three broad purposes:
To assist the auditor in planning the nature, timing, and extent of other auditing
procedures.
As a substantive test to obtain evidential matter about particular assertions related to
account balances or classes of transactions.
As an overall review of the financial information in the final review stage of the audit.
•
•
b.
An auditor’s expectations (types of analytical procedures) are developed from the
following sources of information:
• Financial and operating data.
• Budgets and forecasts.
• Industry publications.
• Competitor information.
c.
The factors that influence an auditor’s consideration of the reliability of data for purposes
of achieving audit objectives are whether the
• Independence of the source of the evidence.
• The effectiveness of internal controls.
• The auditor’s direct personal knowledge.
• Documentary evidence.
• Original documents.
5-24
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a.
The calculation of the expectation for the reserve for returns account can be made as
follows:
Months
July
August
September
October
November
December
Monthly
Sales
(in 000s)
$€
73,300,000
82,800,000
93,500,000
110,200,000
158,200,000
202,500,000
Historical
Return Rate
Estimated
Returns
0.004
0.006
0.01
0.015
0.025
0.032
293,200
496,800
935,000
1653,000
3,955,000
6,480,000
13,813,000
x 0.425
$€5,870,525
Gross Margin %
Auditor expectation
b.
We can establish a tolerable difference by applying a percentage (50-75%) to the
planning materiality set for EarthWear of €1,769,000. This results in a tolerable
difference of €885,000.
c. The expectation of €5,870,525 is approximately €20,000 less the book value of
€5,890,000. Since this amount is less than the tolerable difference of €885,000, the
analytical procedure supports the fair presentation of the reserve for returns account.
d. If the difference between the auditor’s expectation and the book value is greater than
the tolerable misstatement, the auditor should consider performing the following audit
procedures:
• Review the general journal and general ledger for any unusual entries.
• Re-evaluate the historical return rates.
• Re-evaluate the gross profit margin.
• Ask the client to adjust the books.
5-25
Accounts receivable
2005
2004
Accounts receivable turnover
18.1 times
25 times
(sales
divided
by
accounts
receivable)
The
accounts receivable turnover is slower for 2005, which implies that the average collection period
has increased. Arthur should first satisfy himself that RCT’s credit terms remained unchanged
over those years. If the credit terms have been liberalized, this increase in collection period
may be appropriate. Arthur should also satisfy himself that these computations do, in fact,
represent the year’s activity. An accounts receivable aging schedule can indicate whether the
longer collection period is due to a major delinquent customer or is representative of RCT’s
annual activity.
Assuming Arthur is satisfied that RCT’s credit terms have not changed and that annual activity
is fairly represented, he should include more extensive audit procedures for sales and accounts
receivable. The indicated trend may be due to understated sales or overstated accounts
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receivable. Arthur should carefully review the year-end cutoff for sales to verify that sales are
not understated. He should also satisfy himself that there are no unrecorded sales.
Arthur should verify that the accounts receivable are fairly stated at year-end. He should check
that lapping has not occurred. Furthermore, he may wish to expand his normal confirmations to
cover a larger proportion of the receivables. In addition, Arthur should satisfy himself that the
accounts receivable balance includes only bona fide trade receivables.
The changed ratio does not automatically imply that an account is misstated. It merely
highlights an area for further inquiry. It is possible that the changed ratio is perfectly valid and
that the related accounts are fairly stated. If this is so, the auditor should satisfy himself as to
the cause of the changed ratio. For example, RCT may have increased sales by being less
‘selective’ of its customers. Furthermore, tighter economic conditions may have caused
customers to pay their bills more slowly. By inquiry of sales managers, Arthur may find out if
there has been a change in the sales mix of products with varying credit terms.
Current Ratio
200
5
Current ratio
(current assets divided by current
liabilities)
200
4
2.6
8 to 1
2.49
to 1
The increased current ratio was due to an increase in current assets greater than the increase
in current liabilities. Increases in both current assets and current liabilities are warranted
because activity has increased from 2004 to 2005, but the major increase in current liabilities
has been income taxes. The income taxes each year are directly proportional to that year’s
income before income taxes; therefore, the amount of income taxes is logical, assuming that
Arthur is satisfied that each year’s income before taxes is fairly stated. The accounts payable,
however, have declined. Arthur should satisfy himself that the accounts payable are fairly
stated. He should consider the use of confirmation requests and check that the cutoff of
payables was handled properly. He should carefully search for unrecorded payables. He
should investigate substantial decreases in long-term liabilities and should ascertain that current
maturities of long-term liabilities are properly reported in the balance sheet.
A ratio that is inconsistent from one year to the next does not necessarily imply misstatements.
The objective of ratio analysis is to point out areas where further investigation is warranted. The
auditor must satisfy himself that the accounts are fairly stated and that the change is justified.
Solutions to Discussion Cases
5-26 a.
The current-year audit discovered that Forestcrest Woolen Mills had not
completed any construction work on the water treatment facility that must be built to comply with
the consent decree from the Environmental Protection Agency. Failure to complete this facility
on time can result in fines and possible plant closure under the consent decree. This situation
represents a material uncertainty that is likely to be remote at this point in time. However, the
auditor should determine if the client will continue work on the facility and if it can be completed
within the remaining three years. If the client provides some assurance that work will start on
the facility and that construction can be completed on time, the auditor will likely issue a
standard unqualified audit report. The completion information can be obtained from the
company’s president and its construction company. If the client will not provide assurance on
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the future work on the facility and/or the construction cannot be completed on time, the auditor
will have to consider what the potential effects of failure to comply with the consent decree
might be. At this point, it is probably too early to consider issuing an audit report emphasizing a
going concern uncertainty. The auditor might require that client to provide more detailed
disclosure of the issue in the notes to the financial statements.
b.
If these facts were noted at the end of the seventh year of the consent decree, the
auditor would again need information on the possible timely completion of the facility. If the
facility can be completed, the auditor would most likely issue a standard report with an
unmodified opinion. If, however, the facility cannot be completed on time and the penalties
under the consent decree are significant enough to raise doubts about the company's continued
existence, the auditor would likely issue an audit report emphasizing a going concern
uncertainty.
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5-27
1.
Development of Auditor’s Expectation
Four regular games
24,000
Allocation
0.7
0.2
0.1
Total
attendance
Total Fans
16,800
4,800
2,400
24,000
Less free
16,300
4,800
2,400
23,500
Price per
Ticket
12
8
5
Four regular
games
Total
Revenue
195,600
38,400
12,000
246,000
x4
984,000
(30% higher attendance, 20%
higher ticket price)
UniversityAtlantic
31,200
Total
attendance
Allocation
0.7
0.2
0.1
Total Fans
21,840
6,240
3,120
31,200
Less free
21,340
6,240
3,120
30,700
Price per
Ticket
14.40
9.60
6.00
Total
Revenue
307,296
59,904
18,720
385,920
(20% more fans, 75% box
seats, 25% upper deck)
Norwalk
UniversityUnited
Extra fans
3,600
1,200
4,800
Box
Upper
Extra fans -total
Regular game revenue
Price per
Ticket
12
5
Total
Revenue
43,200
6,000
246,000
295,200
Palace (late evening
game)
(10% higher ticket prices, 5%
lower attendance)
Allocation
Less free seats
and 5%
Price per
Ticket
Total
Revenue
15,485
13.20
204,402
0.7
Base
attendance
16,800
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0.2
0.1
4,800
2,400
24,000
4,560
2,280
22,325
8.80
5.50
Total estimated revenue for Oct.Dec.
40,128
12,540
257,070
$€1,922,190
2.
Reported ticket revenue differs from the expectation by approximately 14.5
percent ((2,200,000 – 1,922,190)/1,922,190); this difference is material and should be
investigated. One explanation for the larger than expected reported ticket revenue could be that
the football team performed better than expected. In addition, perhaps the weather also was
better than expected. Auditors can verify ticket sales, perhaps by comparing deposits of ticket
revenue with reported attendance. The auditors also could check weather conditions on game
days to ascertain whether favourable weather conditions are a plausible explanation for the
higher attendance.
3.
In a problem such as this, analytical procedures will be most effective when
accurate expectations can be developed. From this information provided in this problem, it
appears that the auditor’s knowledge of City’s ticket sales is sufficient to allow them to develop a
reasonable expectation.
Solutions to Internet Assignments
5-28 The Institute of Internal Auditors (IIA) home page (www.theiia.org) contains detailed
information about various activities of the IIA. This includes information on the profession,
certification, conferences, products, etc. A search of the Web site identified information about
independence and objectivity.
5-29 A search of the Internet identified a number of potential sources for information on the
mail order industry:
Pegasus Research International, LLC (www.mindbranch.com/) maintains a home page that
contains statistics on E-commerce and the state of the Internet.
• MarketResearch.Com’s home site (www.marketresearch.com/) provides
information on e-commerce and the mail order industry.
• The International Society for Strategic Marketing (www.issm.org) maintains a site
that contains information and statistics on international direct marketing.
• Retail Net’s home page (www.retailnet.com/) provides information on the retail
marketplace industry, including the catalogue and mail order industry.
• Lastly, a number of the major public accounting firms have industry specialization
in retail. The sites of the firms contain information on the retail industry.
5-30 The memo should include information in the text about EarthWear. The information
gathered in Internet assignment 5-29 should provide additional information on the mail order
industry. Chapter 3 discusses materiality for EarthWear and the various risk factors that would
affect the auditor’s risk assessments. EarthWear has a strong control environment and strong
internal controls over its various accounting applications (for example, revenue and purchases
processes). There is a relatively low possibility for errors, fraud, or non-compliance acts.
Comparison of EarthWear’s ratios to industry data indicates that EarthWear’s financial position,
profitability, and solvency are excellent.
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CHAPTER 6
INTERNAL CONTROL IN A FINANCIAL STATEMENT AUDIT
Answers to Review Questions
6-1
From management’s perspective, the internal control provides a way to meet its
stewardship or agency responsibilities. Management also needs a control system that
generates reliable information for decision-making purposes.
The controls that are relevant to the entity’s ability to initiate, record, process, and report
financial data consistent with management’s assertions are the auditor’s main concern. The
auditor needs assurances about the reliability of the data generated within the entity’s internal
control system in terms of how it affects the fairness of the financial statements and how well
the assets and records of the entity are safeguarded.
6-2
Internal control structure is composed of five components:
1.
Control environment: The control environment sets the tone of the organization,
influencing the control consciousness of its people. It is the foundation of all other components
of internal control, providing discipline and structure.
2.
The entity’s risk assessment process: The process for identifying and responding to
business risks and the results thereof. For financial reporting purposes, the entity’s risk
assessment process includes how management identifies risks relevant to the preparation of
financial statements that are fairly presented in accordance with the applicable financial
reporting framework, estimates their significance, assesses the likelihood of their occurrence,
and decides upon actions to manage them.
3.
The Entity’s Information System and Related Business Processes Relevant to Financial
Reporting, and Communication: The information system relevant to financial reporting
objectives, which includes the accounting system, consists of the procedures, whether
automated or manual, and records established to initiate, record, process, and report entity
transactions and to maintain accountability for the related assets, liabilities, and equity.
Communication involves providing an understanding of individual roles and responsibilities
pertaining to internal control over financial reporting.
4.
Control Activities: Control activities are the policies and procedures that help ensure that
management directives are carried out, for example, that necessary actions are taken to
address risks to achievement of the entity’s objectives. Control activities, whether automated or
manual, have various objectives and are applied at various organizational and functional levels.
5.
Monitoring of Controls: It is a process to assess the quality of internal control
performance over time. It involves assessing the design and operation of controls on a timely
basis and taking necessary corrective actions.
6-3
Factors that affect the control environment include:
Communication and enforcement of integrity and ethical values.
A commitment to competence.
•
•
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Participation of those charged with governance (e.g. the board of directors or audit
committee).
Management’s philosophy and operating style.
Organizational structure.
Assignment of authority and responsibility.
Human resource policies and practices.
•
•
•
•
•
6-4
The potential benefits and risks to an entity’s internal control from information technology
include:
Benefits:
•
•
•
•
•
•
Consistent application of predefined business rules and performance of complex
calculations in processing large volumes of transactions or data.
Enhancement of the timeliness, availability, and accuracy of information.
Facilitation of additional analysis of information.
Enhancement of the ability to monitor the performance of the entity’s activities
and its policies and procedures.
Reduction in the risk that controls will be circumvented.
Enhancement of the ability to achieve effective segregation of duties by
implementing security controls in applications, databases, and operating systems.
Risks:
•
•
•
•
•
•
•
Reliance on systems or programs that are inaccurately process data, process
inaccurate data, or both.
Unauthorized access to data that may result in destruction of data or improper
changes to data, including the recording of unauthorized or nonexistent
transactions or inaccurate recording of transactions.
Unauthorized changes to data in master files.
Unauthorized changes to systems or programs.
Failure to make necessary changes to systems or programs.
Inappropriate manual intervention.
Potential loss of data.
6-5
A substantive audit strategy means that the auditor has made a decision not to rely on
the entity’s controls and to audit the related financial statement accounts directly. Control risk is
set at the maximum when a substantive audit strategy is followed. With a reliance strategy, the
auditor relies on the entity’s controls and sets control risk below the maximum. The reliance
strategy requires a more detailed understanding and documentation of internal control than
does the substantive strategy. The auditor also plans and performs tests of controls to support
the lower assessed level of control risk.
6-6
In addition to planning the audit of the financial statements, the auditors understanding
of the entity’s internal control is used to (1) identify the types of potential misstatements, (2)
consider factors that affect the risk of material misstatement, (3) design tests of controls, and (4)
design of substantive tests.
6-7
The concept of reasonable assurance recognizes that the cost of an entity’s internal
control system should not exceed the benefits that are expected to be derived. Thus, an
internal control system will not detect every error that might occur because it would be too costly
to design such a system. Management override of internal control, personnel errors or
mistakes, and collusion are inherent limitations of internal control.
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6-8
A numbers of tools are available to the auditor for documenting the understanding of the
internal control, including copies of the entity’s procedures manuals and organizational charts,
narrative descriptions, internal control questionnaires, and flowcharts.
6-9
The auditor might consider conducting substantive tests at an interim date for a number
of reasons. For example, the client may want the auditor to confirm accounts receivable before
year-end because of demands on the client’s staff at year-end. Alternatively, the auditor may
wish to conduct substantive tests at an interim date to minimize staff overtime at year-end. The
auditor should consider the following factors when substantive tests are to be completed at an
interim date:
•
The control environment.
•
Relevant controls.
•
The objective of the substantive procedure.
•
The assessed risk of misstatement.
•
The nature of the class of transactions or account balances and related assertions.
•
The ability of the auditor to reduce the risk that misstatements existing at the period
end are not detected by performing appropriate substantive procedures combined with tests
of controls to cover the remaining period.
When the auditor conducts substantive tests of an account at an interim date, additional
substantive tests might include comparing the year-end account balance with the interim
account balance, conducting some analytical procedures, and/or reviewing related journals and
ledgers for large or unusual transactions during the remaining period.
6-10 The auditor’s responsibility is to report to those charged with governance or the
appropriate level of management of material weaknesses in the design or implementation of
internal control. A material weakness in internal control is one that could have a material effect
on the financial statements.
Solutions to Problems
6-11
a.
Internal control is design and affected by those charged with governance (e.g. an entity’s
board of directors), management, and other personnel that is designed to provide reasonable
assurance about the achievement of the entity’s objectives in the following categories: (1)
reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3)
compliance with applicable laws and regulations.
b.
In planning an audit, the auditor should obtain an understanding of each of the
components of internal control sufficient to plan the audit by performing procedures to
understand the design of controls relevant to the preparation of financial statements and
whether they have been placed in operation.
c.
An auditor may set control risk at the maximum level for some or all assertions because
the auditor believes controls are unlikely to pertain to an assertion, or are unlikely to be
effective, or because evaluating their effectiveness would be inefficient.
d.
An auditor should document the understanding of the internal control components
obtained to plan the audit. The auditor should document the identified and assessed risks of
material misstatements related to internal controls. When the auditor has tested the controls,
the auditor documents the linkage of the tests with the assessed risks at the assertion level.
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The manner in which these matters are documented is based on the auditor’s professional
judgment.
6-12 The control environment factors (in addition to integrity and ethical values) that establish,
enhance, or mitigate the effectiveness of specific controls, and their components, are:
A Commitment to Competence
Management must specify the competence level for a particular job and translate it into the
required level of knowledge and skill. Management must then hire employees who have the
appropriate competence for a job.
Participation by Those Charged with Governance
Those charged with governance (e.g. the board of directors, supervisory board and audit
committee) significantly influence the control consciousness of the entity. Factors that affect the
effectiveness of those charged with governance include the following: its independence from
management, the experience and stature of its members, the extent of its involvement with and
scrutiny of the entity’s activities, the appropriateness of its actions, the degree to which difficult
questions are raised and pursued with management, and its interaction with the internal and
external auditors.
Managements’ Philosophy and Operating Style
Management’s philosophy and operating style can significantly affect the quality of internal
control. Characteristics that may indicate important information to the auditor about
management’s philosophy and operating style include: (1) management’s approach to taking
and monitoring risks, (2) management’s attitudes and actions towards financial reporting, and
(3) management’s attitudes toward information processing and accounting functions and
personnel.
Organizational Structure
The organizational structure defines how authority and responsibility are delegated and
monitored. Establishing a relevant organizational structure includes considering key areas of
authority and responsibility and appropriate lines of reporting. It provides a framework for
planning, executing, and monitoring operations. An entity develops an organizational structure
that depends on its size and the nature of its business.
Assignment of Authority and Responsibility
This factor includes how authority and responsibility for operating activities are assigned and
how reporting relationships and authorization hierarchies are established. This includes policies
regarding acceptable business practices, the knowledge and experience of key personnel, and
the resources provided for carrying out duties. It also includes policies and communications
directed toward ensuring that all personnel understand the entity’s objectives, know how their
individual actions interrelate and contribute to those objectives, and recognize how and for what
they will be held accountable.
Human Resource Policies and Procedures
The quality of internal control is a direct function of the quality of the personnel operating the
system. The entity should have personnel policies for hiring, training, evaluating, counselling,
promoting, compensating, and taking remedial action.
6-13
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a. The auditor should consider a reliance strategy if evidence is available only in electronic
form. However, after developing an understanding of the new system, the auditor would
need to test the system to determine whether it is working as intended. If the system is
working effectively, the auditor is more likely to use a reliance strategy. The auditor
should also consider whether the firm’s knowledge of IT systems is sufficient to allow it
to use a reliance strategy; if not, a substantive strategy may be more appropriate. The
auditor should, however, be aware that it may be risks involved for which substantive
procedures alone do not provide sufficient appropriate audit evidence.
b. When deciding whether to hire a specialist, the auditor in this case should consider
factors such as the complexity of the new system, whether the implementation of the
system allows the company to engage in electronic commerce and the extent to which
audit evidence is available only in electronic form. The auditor should ask the IT
specialist to communicate information including how IT controls are designed and how
data and transactions are initiated, recorded, processed, and reported.
c. The control environment likely is not affected to a great extent by the switch to an
automated system except inasmuch as the switch might signal management’s
commitment to competence and willingness to improve its controls. The entity’s risk
assessment is affected because the existence of an automated system creates a new
set of risks, such as risks involving the design of the control system. In terms of
information system and communication, the auditor will have to verify that the new
system identifies and records all valid transactions and provides information sufficient for
preparing accurate and complete financial statements. Control activities are important
because new controls regarding the information system will have to be designed and
implemented. Monitoring of controls is important because the monitors (including the
internal and external auditors) will have to have sufficient knowledge of the system to be
able to effectively monitor the use of the system and its outputs.
6-14
a.
The strength of a narrative description is that it provides a simple, written memorandum
that documents the understanding of internal control. However, this may be a weakness
because it may be difficult to describe internal control in sufficient detail using words for effective
analysis of internal controls and the assessment of control risk.
The strength of an internal control questionnaire is that it provides a systematic and
comprehensive way to evaluate internal control. A weakness of using an internal control
questionnaire is that the auditor evaluates the various parts of the internal control system
without an overall view of the system.
A strength of using a flowchart is that it provides a diagrammatic representation of the entity’s
internal control system. This facilitates the auditor’s analysis of the system’s controls. A
weakness of the use of a flowchart is that it may take a considerable amount of time to
complete.
b.
The complexity of an entity’s internal control system can affect the use of the various
tools. For example, when the client’s system is very complex, it is difficult to provide adequate
documentation of the system using a simple narrative description. Conversely, when the entity
has a simple internal control system, completion of a detailed internal control questionnaire will
result in a large number of answers being ‘no’ or ‘not applicable.’ On most audits, the auditor
uses a combination of these tools.
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6-15
a.
Before applying principal substantive procedures to balance sheet accounts at 30 April,
2005, the interim date, Cook should assess the difficulty in controlling incremental audit risk.
Cook should consider whether
• Cook’s experience with the reliability of the accounting records and management’s
integrity has been good.
• Rapidly changing business conditions or circumstances may predispose General’s
management to misstate the financial statements in the remaining period.
• The year-end balances of accounts selected for interim testing will be predictable.
• General’s procedures for analyzing and adjusting its interim balances and for
establishing proper accounting cutoffs will be appropriate.
• General’s accounting system will provide sufficient information about year-end balances
and transactions in the final two months of the year to permit investigation of unusual
transactions, significant fluctuations, and changes in balance compositions that may
occur between the interim and balance sheet dates.
• The cost of the substantive tests necessary to cover the final two months of the year and
provide the appropriate audit assurance at year-end is substantial.
• Assessing control risk at below the maximum would not be required to extend the audit
conclusions from the interim date to year-end. However, if Cook assesses control risk at
the maximum during the final two months, Cook should consider whether the
effectiveness of the substantive tests to cover that period will be impaired.
b.
Cook should design the substantive procedures so that the assurance from those tests
and the tests to be applied as of the interim date, and any assurance provided from the
assessed level of control risk, will achieve the audit objectives at year-end. Such tests should
include the comparison of year-end information with comparable interim information to identify
and investigate unusual amounts. Other analytical procedures and/or substantive procedures
should be performed to extend Cook’s conclusions relative to the assertions tested at the
interim date to the balance sheet date.
Solution to Discussion Case
6-16
a.
Preview Company’s control environment has the following strengths:
Corporate management has high integrity.
Preview has a code of conduct.
Preview hires competent people.
Management is conservative in its use of accounting principles and practices.
The external auditors review controls at each division.
•
•
•
•
•
The control environment has the following weaknesses:
• Divisions operate autonomously with limited monitoring (management intervenes only
when planned results are not obtained).
• The board of directors is not very active.
• There is limited monitoring of employee compliance with the corporate code of conduct.
• Employee compensation is dependent on performance. This in and of itself is not a
weakness. However, with the presence of the other weaknesses, it represents a source
of concern for the auditor.
• Preview does not have an internal audit department.
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b.
The following factors lead to and facilitate Harris’s manipulation of inventory:
As a general manager, Harris has a high incentive to ‘look good.’ His division has had
seven years of increasing profits, and his salary and bonus depend on the division’s
performance.
Competition in the industry is fierce, and sales prices are declining.
Inventory represents a large portion of the balance sheet, and controls over inventory
are weak.
There is limited monitoring by corporate management, and there is no internal audit
department.
•
•
•
•
Solution to Internet Assignments
6-17
Solution is posted on the Instructor’s web page.
6-18
Solution is posted on the Instructor’s web page
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CHAPTER 7
AUDITING INTERNAL CONTROL OVER FINANCIAL REPORTING IN CONJUNCTION WITH
AN AUDIT OF FINANCIAL STATEMENTS
Answers to Review Questions
7-1
Following are management’s and the auditor’s responsibilities under Section 404 of the
Sarbanes-Oxley Act of 2002:
Managements Responsibilities
• Accept responsibility for the effectiveness of the entity’s internal control over financial
reporting.
• Evaluate the effectiveness of the entity’s internal control over financial reporting using
suitable control criteria.
• Support its evaluation with sufficient evidence, including documentation.
• Present a written assessment of the effectiveness of the entity’s internal control over
financial reporting as of the end of the entity’s most recent fiscal year.
Auditor’s Responsibilities
• The auditor must audit and report on management’s assertion about the effectiveness of
internal control.
• The audit of internal control should be ‘integrated’ with the financial statement audit, and
should express an opinion on management’s assertions of internal control over financial
reporting.
• The auditor must plan and perform the audit to obtain reasonable assurance about
whether the entity maintained, in all material respects, effective internal control as of the
date specified in management’s assessment.
7-2
‘Likelihood’ refers to the probability that a misstatement will not be prevented or
detected. For a significant deficiency or a material weakness to exist, the likelihood of such an
occurrence must be more than remote (e.g. either ‘reasonably possible’ or ‘probable’).
‘Magnitude’ refers to the significance that the control deficiency could have on the
financial statements according to the judgment of a reasonable person who considers the
possibility of further undetected misstatements. If likelihood is more than remote and if the
magnitude of the deficiency is more than inconsequential, then either a significant deficiency or
material weakness exists depending on the magnitude of the potential effects of the deficiency
on the entity’s financial statements.
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7-3
All of the following controls would typically be tested:
Controls over initiating, authorizing, recording, processing, and reporting significant
accounts and disclosures and related assertions embodied in the financial statements.
Controls over the selection and application of accounting policies that are in conformity
with generally accepted accounting principles.
Antifraud programs and controls.
Controls, including IT general controls, on which other controls are dependent.
Controls over significant non-routine and non-systematic transactions, such as accounts
involving judgments and estimates.
Company level controls, including (1) the control environment and (2) controls over the
period-end financial reporting process (e.g. controls over procedures used to enter
transaction totals into the general ledger; to initiate, authorize, record, and process
journal entries in the general ledger; and to record recurring and nonrecurring
adjustments to the financial statements).
•
•
•
•
•
•
7-4
Management should document the design of controls over all relevant assertions related
to all significant accounts and disclosures in the financial statements. Documentation should
include a description of each control in place, the business processes to which each control
relates, and the assertions addressed by each control. Finally, the results of management’s
testing and evaluation should be documented.
7-5
The steps in the auditor’s process for an audit of internal control over financial reporting
include:
• Plan the engagement.
• Evaluate management’s assessment process.
• Obtain and document an understanding of internal control.
• Evaluate the design effectiveness of internal control.
• Test and evaluate the operating effectiveness of internal control.
• Form an opinion on the effectiveness of internal control.
7-6
The auditor should classify the significant processes and major classes of transactions
by transaction type: routine, non-routine, and estimation. For each significant business process,
the auditor should:
• Understand the flow of transactions.
• Identify the points within the process at which a misstatement related to each relevant
financial statement assertion could arise.
• Identify the controls that management has implemented to address these potential
misstatements.
• Identify the controls that management has implemented over the prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s assets (AS2,
¶74).
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7-7
The period-end financial reporting process controls include procedures used to enter
transaction totals into the general ledger; initiate, authorize, record, and process journal entries
in the general ledger; record recurring and nonrecurring adjustments to the annual and quarterly
financial statements; and draft annual and quarterly financial statements and related
disclosures.
The auditor’s evaluation of the period-end financial reporting process includes the inputs,
procedures performed, and outputs of the processes the company uses to produce its annual
and quarterly financial statements. The auditor should also consider the extent of IT
involvement in each period-end financial reporting process element, who participates from
management, the number of locations involved, types of adjusting entries, and the nature and
extent of the oversight of the process by appropriate parties, including management, the board
of directors, and the audit committee.
7-8
Walkthroughs help the auditor to confirm his or her understanding of control design and
transaction process flow, to determine whether all points at which misstatements could occur
have been identified, to evaluate the effectiveness of the design of controls, and to confirm
whether controls have been placed in operation (AS2, ¶79).
7-9
The circumstances that should be regarded as at least significant deficiencies and as
strong indicators of a material weakness include:
• Restatement of previously issued financial statements to reflect the correction of a
misstatement.
• Identification by the auditor of a material misstatement in financial statements in the
current period that was not initially identified by the company’s internal control over
financial reporting.
• Oversight of the company’s external financial reporting and internal control over financial
reporting by the company’s audit committee is ineffective.
• The internal audit function or the risk assessment function is ineffective at a company for
which such a function needs to be effective for the company to have an effective
monitoring or risk assessment component, such as for very large or highly complex
companies.
• For complex entities in highly regulated industries, an ineffective regulatory compliance
function. This relates solely to those aspects of the ineffective regulatory compliance
function in which associated violations of laws and regulations could have a material
effect on the reliability of financial reporting.
• Identification of fraud of any magnitude on the part of senior management.
• Significant deficiencies that have been communicated to management and the audit
committee remain uncorrected after some reasonable period of time.
• An ineffective control environment. (AS2, ¶140)
These circumstances are ‘red flags’ for potential problems in the control environment.
Because the nature of the audit report depends on the significance of such weaknesses, the
PCAOB does not want them to be overlooked.
7-10 When evaluating the competence and objectivity of others, the auditor should consider
the following factors:
Competence:
• Their educational level and professional experience.
• Their professional certification and continuing education.
• Practices regarding the assignment of individuals to work areas.
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Supervision and review of their activities.
Quality of the documentation of their work, including any reports or recommendations
issued.
Evaluation of their performance.
•
•
•
Objectivity:
• The organizational status of the individuals responsible for the work of others in testing
controls, including—
a. Whether the testing authority reports to an officer of sufficient status to ensure sufficient
testing coverage and adequate consideration of, and action on, the findings and
recommendations of the individuals performing the testing.
b. Whether the testing authority has direct access and reports regularly to the board of directors
or the audit committee.
c. Whether the board of directors or the audit committee oversees employment decisions
related to the testing authority.
• Policies to maintain the individuals’ objectivity about the areas being tested, including—
a. Policies prohibiting individuals from testing controls in areas in which relatives are employed
in important or internal control sensitive positions.
b. Policies prohibiting individuals from testing controls in areas to which they were recently
assigned or are scheduled to be assigned upon completion of their controls testing
responsibilities. (AS2, ¶119-120)
7-11 AS2 requires that the auditor appropriately document the processes, procedures,
judgments, and results relating to the audit of internal control. The auditor’s documentation
must include the auditor’s understanding and evaluation of the design of each of the
components of the entity’s internal control over financial reporting. The auditor also documents
the process used to determine, and the points at which misstatements could occur within,
significant accounts, disclosures, and major classes of transactions. The auditor must justify
and document the extent to which he or she relied upon work performed by others. Finally, the
auditor must describe the evaluation of any deficiencies discovered as well as any other findings
that could result in a modification to the auditor’s report. (AS2, ¶159)
7-12 The auditor’s report contains opinions on two separate items: (1) management’s
assessment of the effectiveness of internal control over financial reporting, and (2) the
effectiveness of internal control over financial reporting based on the auditor’s independent audit
work. Similar to reports relating to the financial statement audit, the basic options for the
opinions are unqualified, qualified, and adverse.
The auditor’s opinion relating to management’s assessment simply depends on whether
the auditor agrees with management’s conclusion regarding the effectiveness of internal control
over financial reporting. If the auditor agrees, the opinion on management’s assessment will be
unqualified. If the auditor disagrees, the opinion will be adverse.
With respect to the auditor’s opinion on the effectiveness of a client’s internal control, an
unqualified opinion signifies that the client’s internal control is designed and operating effectively
in all material respects. Significant deficiencies relate to possible financial statement errors that
are less than material, and therefore do not require a departure from an unqualified opinion. A
qualified opinion is issued under certain circumstances involving limitations on the scope of the
auditor’s work; however, serious scope limitations require the auditor to disclaim an opinion. An
adverse opinion is required if a material weakness is identified. Figure 7-3 illustrates the types
of auditor’s reports and the circumstances leading to each.
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7-13 The auditor should take into account all of the following items when deciding which
locations or business units to test:
• The relative financial significance of each location or business unit.
• The risk of material misstatement arising from each location or business unit.
• The similarity of business operations and internal control over financial reporting at the
various locations or business units.
• The degree of centralization of processes and financial reporting applications.
• The effectiveness of the control environment, particularly management’s direct control
over the exercise of authority delegated to others and its ability to effectively supervise
activities at the various locations or business units. An ineffective control environment
over the locations or business units might constitute a material weakness.
• The nature and amount of transactions executed and related assets at the various
locations or business units.
• The potential for material unrecognized obligations to exist at a location or business unit
and the degree to which the location or business unit could create an obligation on the
part of the company.
• Management’s risk assessment process and analysis for excluding a location or
business unit from its assessment of internal control over financial reporting. (AS2, ¶
B10)
7-14 When a significant period of time has elapsed between the time period covered by the
tests of controls in the service auditor’s report and the date of management’s assessment,
additional procedures should be performed. The auditor should consider the results of relevant
procedures performed by management or the auditor, how much time has passed since the
service auditor’s report, the significance of the activities of the service organization, whether
errors have been identified in the service organization’s processing, and the nature and
significance of any changes in the service organization’s controls. As these factors increase in
significance, the need for the auditor to obtain additional evidence increases.
7-15 Generalized audit software (GAS) includes programs that allow the auditor to perform
tests on computer files and databases. It was developed so that auditors would be able to
conduct similar computer-assisted audit techniques in different IT environments. Custom audit
software is generally written by auditors for specific audit tasks. Such programs are necessary
when the entity’s computer system is not compatible with the auditor’s GAS or when the auditor
wants to conduct some testing that may not be possible with the GAS.
Some functions that can be performed by GAS are: (1) file or database access, (2) selection of
transactions that meet certain criteria, (3) arithmetic functions, (4) statistical analyses, and (5)
report generation.
Solutions to Problems
7-16
Control 1: Monthly Manual Reconciliation
Nature, Timing, and Extent of Procedures.
Objective of the Test: To determine whether misstatements in accounts receivable (existence,
valuation, and completeness) would be detected on a timely basis.
Test the company’s reconciliation control by selecting a sample of reconciliations based upon
the number of accounts, the dollar value of the accounts, and the volume of transactions
affecting the account. Perform the following tests on the reconciliation process:
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a.
Make inquiries of personnel performing the control. Ask the employee performing the
reconciliation the following questions:
•
What documentation describes the account reconciliation process?
•
How long have you been performing the reconciliation work?
•
What is the reconciliation process for resolving reconciling items?
•
How often are the reconciliations formally reviewed and signed off?
•
If significant issues or reconciliation problems are noticed, to whose attention do you
bring them?
•
On average, how many reconciling items are there?
•
How are old reconciling items treated?
•
If need be, how is the system corrected for reconciling items?
•
What is the general nature of these reconciling items?
b.
Observe the employee performing the control. For nonrecurring reconciling items,
observe whether each item included a clear explanation as to its nature, the action that had
been taken to resolve it, and whether it had been resolved on a timely basis.
c.
Reperform the control for two months by inspecting the reconciliations and reperforming
the reconciliation procedures. Scan through the file of all reconciliations prepared during the
year and note that they had been performed on a timely basis.
d.
Make inquiries of company personnel and determined that the reconciliation procedures
have not changed from interim to year-end.
Control 2: Daily Manual Preventive Control
Nature, Timing, and Extent of Procedures.
Objective of the Test: To determine whether misstatements in cash (existence) and accounts
payable (existence, valuation, and completeness) would be prevented on a timely basis.
Test the control over making a cash disbursement only after matching the invoice with the
receiver and purchase.
Select 25 disbursements (voucher packages) from the cash disbursement registers from
January through September. Performed the following procedures:
a.
Examine the invoice to see if it includes the signature or initials of the accounts payable
clerk, evidencing the clerk’s performance of the matching control.
b.
Reperformed the matching control corresponding to the signature by examining the
invoice to determine that (a) its items matched to the receiver and purchase order and (b) it was
mathematically accurate.
c.
Update the testing through the end of the year by asking the accounts payable clerk
whether the control was still in place and operating effectively. Perform a walkthrough of one
transaction in December.
Control 3: Programmed Preventive Control and Weekly Information TechnologyDependent Manual Detective Control
Nature, Timing, and Extent of Procedures.
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Objective of the Test: To determine whether misstatements in cash (existence) and accounts
payable/inventory (existence, valuation, and completeness) would be prevented or detected on
a timely basis.
Test the programmed application control of matching the receiver, purchase order, and invoice
as well as the review and follow-up control over unmatched items. To test the programmed
application control, perform the following procedures:
a.
Identify, through discussion with company personnel, the software used to process
receipts and purchase invoices.
b.
Determine, through further discussion with company personnel, that they do not modify
the core functionality of the software, but sometimes make personalized changes to reports to
meet the changing needs of the business.
c.
Establish, through further discussion, that the inventory module operated the receiving
functionality, including the matching of receipts to open purchase orders.
d.
Identify, through discussions with the client and review of the supplier’s documentation,
the names, file sizes (in bytes), and locations of the executable files (programs) that operate the
functionality under review.
e.
Identify the objectives of the programs to be tested; i.e. whether appropriate items are
received (for example, match a valid purchase order), appropriate purchase invoices are posted
(for example, match a valid receipt and purchase order, non-duplicate reference numbers) and
unmatched items (for example, receipts, orders or invoices) are listed on the exception report.
f.
Determine whether the programmed control is operating effectively by performing a
walkthrough in the month of July.
Test the detect control of review and follow up on the Unmatched Items Report, by performing
the following procedures in the month of July for the period January to July:
a.
Make inquiries of the employee who follows up on the weekly-unmatched items reports
and determine why items appear on it.
b.
Observed the performance of the control.
c.
Reperformed the control.
d.
Determine that the company had not made significant changes in their controls from
interim to year-end by discussing with company personnel the procedures in place for making
such changes.
7-17
a.
Based only on these facts, this deficiency represents a significant deficiency for the
following reasons: The magnitude of a financial statement misstatement resulting from this
deficiency would reasonably be expected to be more than inconsequential, but less than
material, because individual sales transactions are not material and the compensating detective
controls operating monthly and at the end of each financial reporting period should reduce the
likelihood of a material misstatement going undetected. Furthermore, the risk of material
misstatement is limited to revenue recognition errors related to shipping terms as opposed to
broader sources of error in revenue recognition. However, the compensating detective controls
are only designed to detect material misstatements. The controls do not effectively address the
detection of misstatements that are more than inconsequential but less than material, as
evidenced by situations in which transactions that were not material were improperly recorded.
Therefore, there is a more than remote likelihood that a misstatement that is more than
inconsequential but less than material could occur. (See AS2, A-138, Example D2 – Scenario
A.)
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b.
Based only on these facts, this deficiency represents a material weakness for the
following reasons: The magnitude of a financial statement misstatement resulting from this
deficiency would reasonably be expected to be material, because individual sales transactions
are frequently material, and gross margin can vary significantly with each transaction (which
would make compensating detective controls based on a reasonableness review ineffective).
Additionally, improper revenue recognition has occurred, and the amounts have been material.
Therefore, the likelihood of material misstatements occurring is more than remote. Taken
together, the magnitude and likelihood of misstatement of the financial statements resulting from
this internal control deficiency meet the definition of a material weakness. (See AS2, A-139,
Example D2 – Scenario B.)
c.
Based on only these facts, this deficiency represents a material weakness for the
following reasons: The magnitude of a financial statement misstatement resulting from this
deficiency would reasonably be expected to be material, because the frequency of occurrence
allows insignificant amounts to become material in the aggregate. The likelihood of material
misstatement of the financial statements resulting from this internal control deficiency is more
than remote (even assuming that the amounts were fully reserved for in the company’s
allowance for uncollectible accounts) due to the likelihood of material misstatement of the gross
accounts receivable balance. Therefore, this internal control deficiency meets the definition of a
material weakness. (See AS2, A-139, Example D2 – Scenario C.)
7-18
a.
Based only on these facts, the combination of these significant deficiencies represents a
material weakness for the following reasons: Individually, these deficiencies were evaluated as
representing a more than remote likelihood that a misstatement that is more than
inconsequential, but less than material, could occur. However, each of these significant
deficiencies affects the same set of accounts. Taken together, these significant deficiencies
represent a more than remote likelihood that a material misstatement could occur and not be
prevented or detected. Therefore, in combination, these significant deficiencies represent a
material weakness. (See AS2, A-140, Example D3 – Scenario A.)
b.
Based only on these facts, the auditor should determine that the combination of these
significant deficiencies represents a material weakness for the following reasons:
• The balances of the loan accounts affected by these significant deficiencies have
increased over the past year and are expected to increase in the future.
• This growth in loan balances, coupled with the combined effect of the significant
deficiencies described, results in a more than remote likelihood that a material
misstatement of the allowance for credit losses or interest income could occur.
Therefore, in combination, these deficiencies meet the definition of a material weakness. (See
AS2, A-140-141, Example D2 – Scenario B.)
7-19
a.
If the lack of an adequate antifraud program is considered a material deficiency by the
auditor because of increased risk, then the auditor should issue an adverse opinion. However,
if it is only considered to be a significant deficiency, then an unqualified report can be issued.
b.
An unqualified report should be issued as no control deficiencies were identified.
c.
Because the auditor identified a material misstatement in the financial statements, an
adverse report on Fritz’s internal control over financial reporting must be issued.
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d.
The auditor must determine the magnitude of the possible misstatement of non-routine
sales. If it is determined to be material then an adverse opinion should be issued. However, if
materiality is not a concern, an unqualified opinion may be given.
e.
Most likely an adverse opinion would be issued, unless the risk of compliance violations
was not material.
7-20
a.
The auditor must determine whether the restatements are significant or material
deficiencies. If material, an adverse opinion will be issued, otherwise an unqualified report may
be given.
b.
If other controls over financial reporting are present, the auditor may issue an unqualified
opinion. However, if the deficiency carries a high risk of material misstatement, then an adverse
opinion should be issued.
c.
The auditor would most likely issue an adverse opinion because of the importance of the
audit committee in the control process.
d.
If the ineffective monitoring component is a material deficiency, then an adverse opinion
should be issued. Otherwise, an unqualified opinion may be given.
e.
The significance of financial fraud by the CFO is a material weakness and an adverse
opinion should be issued.
f.
Depending on the amount of risk of material misstatement due to the ineffective control
environment, the auditor will issue an adverse opinion or an unqualified opinion.
g.
Given the lack of management’s concern for internal control, an adverse opinion should
be issued.
7-21
a.
The auditor does not agree with Barns Security Systems management assessment and
should therefore issue an adverse opinion.
b.
As long as the auditor agrees with company’s assessment of controls, an unqualified
report can be issued. However, AS2 paragraph 166 indicates that controls must operate for a
sufficient time period to accommodate management and auditor testing. This does not appear
to be possible in the scenario when the changes were made after management’s assessment.
c.
The auditor should issue an adverse opinion if he or she does not believe sufficient time
has passed to gather sufficient, competent evidence that the control deficiencies have been
corrected.
7-22 The audit report should include the proper title; introductory, scope, definition, limitations,
opinion, and explanatory paragraphs; and should describe the reason for the material
weakness. An example can be found in Exhibit 7-5.
7-23 The audit report should include the proper title; introductory, scope, definition, limitations,
and opinion paragraphs; and should describe the reason for the material weakness. An
example can be found in Exhibit 18-20.
7-24
a.
b.
c.
2
3
1
7-25 The substantive auditing procedures Brown may consider performing include the
following:
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Using the perpetual inventory file:
•
Recalculate the beginning and ending balances (prices x quantities), foot, and print
out a report to be used to reconcile the totals with the general ledger (or agree beginning
balance with the prior year’s working papers).
•
Calculate the quantity balances as of the physical inventory date for comparison to
the physical inventory file. (Alternatively, update the physical inventory file for purchases
and sales from 6 January to 31 January, 2005, for comparison to the perpetual inventory at
31 January, 2005.)
•
Select and print out a sample of items received and shipped for the periods (1) before
and after 5 January and 31 January, 2005, for cutoff testing, (2) between 5 January and 31
January, 2005, for vouching or analytical procedures, and (3) prior to 5 January, 2005, for
tests of details or analytical procedures.
•
Compare quantities sold during the year to quantities on hand at year-end. Print out a
report of items for which turnover is less than expected. (Alternatively, calculate the number
of days’ sales in inventory for selected items.)
•
Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further consideration.
•
Recalculate the prices used to value the year-end FIFO inventory by matching prices
and quantities to the most recent purchases.
•
Select a sample of items for comparison to current sales prices.
•
Identify and print out unusual transactions. (These are transactions other than
purchases or sales for the year, or physical inventory adjustments as of 5 January, 2005.)
•
Recalculate the ending inventory (or selected items) by taking the beginning balances
plus purchases, less sales (quantities and /or amounts), and print out the differences.
•
Recalculate the cost of sales for selected items sold during the year.
Using the physical inventory and test count files:
•
Account for all inventory tag numbers used and print out a report of missing or
duplicate numbers for follow-up.
•
Search for tag numbers noted during the physical inventory observation as being
voided or not used.
•
Compare the physical inventory file to the file of test counts and print out a report of
differences for the auditor follow-up.
•
Combine the quantities for each item appearing on more than one inventory tag
number for comparison to the perpetual file.
•
Compare the quantities on the file to the calculated quantity balances on the
perpetual inventory file as of 5 January, 2005. (Alternatively, compare the physical
inventory file updated to year-end to the perpetual inventory file.)
•
Calculate the quantities and dollar amounts of the book-to-physical adjustments for
each item and the total adjustment. Print out a report to reconcile the total adjustment to the
adjustment recorded in the general ledger before year-end.
•
Using the calculated book-to-physical adjustments for each item, compare the
quantity and dollar amount of each adjustment to the perpetual inventory file as of 5
January, 2005, and print out a report of differences for follow-up.
INTERNET ASSIGNMENTS
7-26 The opinion paragraph of the audit report will indicate whether the report is for both
audits. Note that even separate reports on each of the audits (of financial statements and
controls) will refer to the conclusion reached on the other audit.
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7-27 The opinion paragraph of an integrated audit will indicate the auditor’s opinion with respect
to the effectiveness of internal control.
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CHAPTER 8
AUDIT SAMPLING: AN OVERVIEW AND APPLICATION TO TESTS OF CONTROLS
Answers to Review Questions
8-1
Audit sampling is the application of an audit procedure to less than 100 per cent of the
items within an account balance or class of transactions for the purpose of evaluating some
characteristic of the balance or class. The justification for accepting some uncertainty from
sampling is due to the trade-off between the cost to examine all of the data and the cost of
making an incorrect decision based on a sample of the data.
8-2 Type I and Type II errors are the two types of decision errors an auditor can make when
deciding that sample evidence supports or does not support a test of controls or a
substantive test based on a sampling application.
In reference to a test of controls Type I and Type II errors are:
•
Risk of incorrect rejection (Type I): the risk that the assessed level of control risk
based on the sample is greater than the true operating effectiveness of the control. Also
commonly referred to as the risk of assessing control risk too high or the risk of
underreliance.
•
Risk of incorrect acceptance (Type II): the risk that the assessed level of control risk
based on the sample is less than the true operating effectiveness of the control. Also
commonly referred as the risk of assessing control risk too low or the risk of overreliance.
In reference to substantive tests Type I and Type II errors as follows:
•
Risk of incorrect rejection (Type I): the risk that the sample supports the conclusion
that the recorded account balance is materially misstated when it is not materially misstated.
•
Risk of incorrect acceptance (Type II): the risk that the sample supports the
conclusion that the recorded account balance is not materially misstated when it is materially
misstated.
The risk of incorrect rejection relates to the efficiency of the audit because such errors can result
in the auditor’s conducting more audit work than necessary in order to reach the correct
conclusion. The risk of incorrect acceptance relates to the effectiveness of the audit because
such errors can result in the auditor failing to detect a material misstatement in the financial
statements. This can lead to litigation against the auditor by the parties who relied on the
financial statements.
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8-3
•
•
•
•
•
•
•
8-4
Audit evidence choices that do not involve audit sampling include:
Analytical procedures.
Scanning.
Inquiry.
Observation.
Procedures applied to every item in the population.
Classes of transactions or account balances not tested.
Tests of automated information technology controls.
Non-statistical sampling is an approach in which the auditor uses a haphazard selection
technique or uses judgment in either or both of the following steps:
• Determining the sample size
• Calculating the computed upper deviation rate
Non-statistical sampling doesn’t require the use of statistical theory to determine sample size or
in the evaluation of sampling risk. Statistical sampling, on the other hand, uses the laws of
probability to determine sample size, to select, and to evaluate the results of an audit sample.
The use of statistical theory permits the auditor to quantify the sampling risk for the purpose of
reaching a conclusion about the population.
The major advantages of a statistical sampling application are that it helps the auditor (1) design
an efficient sample, (2) measure the sufficiency of evidence obtained, and (3) quantify sampling
risk. The disadvantages of statistical sampling include the additional costs of (1) training
auditors in the proper use of sampling techniques and (2) the added complexity of designing
and conducting the sampling application.
8-5
Attribute sampling is used to estimate the proportion of a population that possesses a
specified characteristic. For tests of controls, the auditor wants to measure the deviation rate to
determine whether the control activity can be relied upon to properly process accounting
transactions and therefore support the auditor’s assessed level of control risk.
8-6
Once the population has been defined, the auditor must determine (1) that the physical
representation of the population is complete, (2) the period to be covered by the test, and (3)
whether to conduct additional tests in the remaining period.
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8-7
The four factors that enter into the sample size decision and their relationship with
sample size are:
Factor
Relationship to Sample Size
The risk of incorrect rejection
Inverse
The tolerable deviation rate
Inverse
The expected population deviation rate
Direct
The population size
Decreases sample size only when
population size is small (<500 items)
8-8
In conducting the audit procedures for tests of controls, the auditor may encounter
voided documents, inapplicable documents, or missing documents. Each of these situations
should be handled in the following manner for an attribute sampling application:
•
Voided documents: If the transaction has been properly voided, it does not represent
a deviation. The item should be replaced with a new sample item.
•
Unused or inapplicable documents: Sometimes a selected item is not appropriate for
the definition of the control. In such a case, the item is not a deviation and the auditor would
simply replace the item with another purchase transaction.
•
Missing documents: If the auditor is unable to examine a document or use an
alternative procedure to test whether the control was adequately performed, the sample item
is a deviation for purposes of evaluating the sample results.
8-9
The auditor’s purposes in evaluating the qualitative aspects of deviations in performing
error analysis involves considering (1) the nature of the deviations and their causes and (2) how
these deviations may impact the other phases of the audit.
8-10 The AICPA Audit Procedures Study Audit Sampling provides the following advice for
considering sampling risk in a non-statistical test of controls
...it is generally appropriate for the auditor to assume that the sample results do not support the
planned assessed level of control risk if the rate of deviation identified in the sample exceeds
the expected population deviation rate used in designing the sample. In that case there is likely
to be an unacceptably high risk that the true deviation rate in the population exceeds the
tolerable rate. If the auditor concludes that there is an unacceptably high risk that the true
population deviation rate could exceed the tolerable rate, it might be practical to expand the test
to sufficient additional items to reduce the risk to an unacceptable level. Rather than testing
additional items, however, it is generally more efficient to increase the auditor’s assessed level
of control risk because the results of the sample would generally support a higher level of
control risk.
Solutions to Problems
8-11 a.
The auditor’s justification for accepting the uncertainties that are inherent in the
sampling process are based upon the premise that (1) the cost of examining all of the financial
data would usually outweigh the benefit of the added reliability of a complete (100%)
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examination and (2) the time required to examine all of the financial data would usually preclude
issuance of a timely auditor’s report.
b.
The uncertainties inherent in applying auditing procedures are collectively referred to as
audit risk. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the
opinion on financial statements that are materially misstated. Audit risk can be controlled
through the scope of the auditor’s test procedures with the audit risk model providing a
framework to follow. Detection risk, which is a component of the audit risk model, is composed
of two risks or uncertainties: sampling risk and non-sampling risk.
c.
Sampling risk arises from the possibility that, when a test of controls or a substantive test
is restricted to a sample, the auditor’s conclusions may be different from the conclusions he or
she would reach if the test were applied in the same way to all items in the population.
Non-sampling risk includes all the aspects of audit risk that are not due to sampling and can
occur because the auditor used an inappropriate audit procedure, failed to detect a
misstatement when applying an appropriate audit procedure, or misinterpreted an audit result.
When performing a test of controls, the auditor can commit two types of decision errors: (1) the
risk of incorrect rejection or of assessing control risk too high, which is the risk that the assessed
level of control risk based on the sample is greater than the true operating effectiveness of the
control, and (2) the risk of incorrect acceptance or of assessing control risk too low, which is the
risk that the assessed level of control risk based on the sample is less than the true operating
effectiveness of the control.
When performing substantive tests, the related decision errors are: (1) the risk of incorrect
rejection, which is the risk that the sample supports the conclusion that the recorded account
balance is materially misstated when it is not materially misstated, and (2) the risk of incorrect
acceptance, which is the risk that the sample supports the conclusion that the recorded account
balance is not materially misstated when it is materially misstated.
8-12
1.
2.
3.
4.
5.
6.
Does not involve sampling.
Involves sampling.
Does not involve sampling.
Involves sampling.
Involves sampling.
Does not involve sampling.
8-13
1. In this scenario, the stratum of loans greater than €1 million is tested in total. Since the
entire population is tested, it does not involve sampling. Sampling is involved in the
second strata because the auditor is only examining 15 of the 450 loans in the strata.
2. If the analytical procedures used do not include statistical techniques (e.g. regression
analysis), then the use of analytical procedures does not involve sampling.
3. Since the auditor has selected less than 100% of the population’s transactions, sampling
is involved in such a test.
4. In this case, the auditor has decided not to audit the account because it is immaterial.
This approach does not involve sampling.
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8-14 a.
The text includes Jenny’s step 3 within the second step of attributes sampling.
The remaining steps of attribute sampling are as follows:
2.
Define remaining population characteristics—define the control deviation conditions.
3.
Determine sample size, using the following inputs.
•
Determine the desired confidence level.
•
Determine the tolerable deviation rate.
•
Determine the expected population deviation rate.
4.
Select sample items.
5.
Perform the audit procedures—understand and analyze a deviations observed.
6.
Calculate the sample deviation and computed upper deviation rates.
7.
Draw final conclusions.
b.
The advantages of using a statistical sampling methodology are that it helps the auditor
(1) design an efficient sample, (2) measure the sufficiency of the evidence obtained, and (3)
quantify sampling risk. By using a statistical sampling methodology, the auditor can limit
sampling risk to an acceptable level.
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8-15
The sample size for each control activity is:
Control Activity
Parameters
1
Risk of incorrect acceptance
5
%
Tolerable deviation rate
4
Expected population deviation rate
5
1
Sample size
6
7
2
15
8
%
3
%
1
81
10
%
%
%
4
1
0%
%
%
3
5
%
%
8-16
are:
2
4
%
9
98
4
The computed upper deviation rate and the auditor’s decision for each control activity
Control Activity
Results
1
2
3
4
Number of deviations
0
5
4
3
Sample size
156
181
94
98
Sample deviation rate
0.0
2.8
4.3
3.1
Computed upper deviation rate
2.0
Supports
6.9
Does not
support
8.7
Does not
support
7.3
Supports
3
4
Auditor’s decision
8-17
The sample size for each control activity is:
Control Activity
Parameters
1
2
Risk of incorrect acceptance
5%
5%
10%
10%
Tolerable deviation rate
6%
7%
4%
3%
Expected population deviation rate
2%
2%
1%
0%
Sample size
127
88
96
76
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8-18
are:
The computed upper deviation rate and the auditor’s decision for each control activity
Control Activity
Results
1
2
3
4
Number of deviations
4
2
2
0
Sample size
127
88
96
76
Sample deviation rate
3.1
2.3
2.1
0.0
Computed upper deviation rate
7.2
Does not
support
7.7*
Does
Support
5.9
Does not
support
3.3*
Does
Support
Auditor’s decision
* It appears that the computed upper deviation rate exceeds the tolerable deviation rate for both
procedure 2 and 4. However, these results obtain because the evaluation tables do not have
include evaluations for sample sizes of 88 and 76 and when rounded down to sample sizes of
80 and 70 respectively, the computed upper deviation rate of 7.7% and 3.3%. In reality,
because a statistically derived sample size was determined in problem 8-27 and because the
allowed number of deviations were found (see the number in parentheses in tables 8-7 and 88), the auditor is guaranteed that the results are acceptable. Note that when using ACL,
rounding is not a potential source for auditor error.
8-19 Austen’s conclusion on each item would be as follows:
1.
The sample deviation rate is 2.5 per cent (1 ÷ 40). Since the sample deviation rate is
less than the expected population deviation rate of 3 per cent, the control can be relied upon.
2.
The sample deviation rate is 5.0 per cent (1 ÷ 20). Since the sample deviation rate
exceeds the expected population deviation rate of 4 per cent, the control cannot be relied upon.
8-20 a.
The allowance for sampling risk is the difference between the upper deviation
rate and the sample deviation rate. In this problem, the upper deviation rate is given as 7% and
the sample deviation rate is 4% (6 deviations/150 sample size). Therefore, the allowance for
sampling risk is 3% (7% - 4%).
b.
(1) The tolerable deviation rate exceeds the sample deviation rate, but is less
than the upper deviation rate. Therefore, Mathews could increase the sample size and
reevaluate the results based on the larger sample size before determining whether to adjust the
preliminary control risk assessment.
(2) Mathews could increase control risk because the upper deviation rate exceeds the
tolerable deviation rate and the sample deviation rate exceeds the expected deviation rate.
(3) Mathews could justify not adjusting the preliminary assessment because, even though the
upper deviation rate exceeds the tolerable rate, the sample deviation rate still is less than the
tolerable rate. However, he must recognize that this approach does not leave much allowance
for sampling risk.
8-21
Iceberge’s conclusion on each item would be as follows:
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1.
The sample deviation rate is 2.0 per cent (1 ÷ 50). Since the sample deviation rate is
less than the expected population deviation rate of 3 per cent, the control can be relied upon.
2.
The sample deviation rate is 4.0 per cent (2 ÷ 50). Since the sample deviation rate
exceeds the expected population deviation rate of 3 per cent, the control cannot be relied upon.
Solution to Discussion Case
8-22 The following are the incorrect assumptions, statements, and inappropriate applications
of attribute sampling in Baker’s procedures:
• Statistical sampling does not eliminate the need for professional judgment.
• The computed upper deviation rate is too high (20%) if Baker plans to assess control risk
at a low level.
• Discovery sampling is not an appropriate sampling technique in this attribute sampling
application.
• The sampling technique employed is not discovery sampling.
• The increase in the population size has little or no effect on determining sample size.
• Baker failed to consider the risk of assessing control risk too low in determining the
sample size.
• The population from which the sample was chosen (invoices) was an incorrect
population.
• The sample was not randomly selected.
• Baker failed to consider the difference of an immaterial amount to be an error.
• The allowance for sampling risk was incorrectly calculated.
• Baker’s reasoning concerning the decision that the sample supported a low assessed
level of control risk was erroneous.
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CHAPTER 9
AUDIT SAMPLING: AN APPLICATION TO SUBSTANTIVE TESTS OF ACCOUNT
BALANCES
Answers to Review Questions
9-1
The steps in a statistical sampling application for substantive testing include (by phases):
Planning:
• Determine the test objectives.
•
Define the population characteristics:
o Define the population.
o Define the sampling unit.
o Define a misstatement.
•
Determine sample size, using the following inputs:
o The desired confidence level or risk of incorrect acceptance.
o The tolerable misstatement.
o The expected population misstatement.
o Population size.
Performance:
•
Select sample items.
•
Perform the audit procedures:
o Understand and analyze any misstatements observed
Evaluation:
•
Calculate the projected misstatement and the upper limit on misstatement.
•
Draw final conclusions.
9-2
When monetary-unit sampling (MUS) is used, the sampling unit is defined as an
individual euro (or similar form of currency). When classical variables sampling is used, the
sampling unit is a customer account, an individual transaction, or a line item on a transaction.
Solutions Manual, Chapter 9
©The McGraw-Hill Companies, Inc., 2006
9-1
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9-3
The following table shows how the desired confidence level, tolerable misstatement, and
expected misstatement are related to sample size:
Factor
Relationship to Sample Size
Desired confidence level
Direct
Tolerable misstatement
Inverse
Expected misstatement
Direct
The advantages and disadvantages of MUS are:
9-4
Advantages:
•
When the auditor expects no misstatements, MUS will normally result in a smaller
sample size than classical variables sampling.
•
The calculation of sample size and the evaluation of the sample results are not based
on the variation (that is, the standard deviation) between items in the population.
•
MUS, when applied using a probability proportional to size sample selection
procedure as outlined in the text, automatically results in a stratified sample because
sampled items are selected in proportion to their monetary amount.
Disadvantages:
•
Selection of a zero or negative balance generally requires special design
consideration.
•
The general approach to MUS assumes that the audited amount of the sample item is
not in error by more than 100 per cent.
•
When more than one or two misstatements are detected using a MUS approach, the
sample results calculations may overstate the allowance for sampling risk.
9-5
Probability-proportional-to-size sample selection gives each individual euro or monetary
unit in the population an equal chance of being selected. Each selected euro represents a
group of euros (referred to as the sampling interval). The sampling interval is determined by
dividing the book value of the population by the sample size. The advantage of using this
approach to selecting the sample is that while each euro in the population has an equal chance
of being selected, logical units (e.g. customer accounts) containing more euros have a higher
probability of being selected.
9-6
The decision rule for determining the acceptability of sample results when MUS is used
compares the tolerable misstatement (TM) to the upper misstatement limit (UML). If UML is
less than TM, the evidence supports the fair presentation of the account. If UML is greater than
TM, the evidence does not support the fair presentation of the account balance.
9-7
Variation in the population, the risk of incorrect acceptance, and tolerable and expected
misstatement affect sample size in the following way:
•
Variation in the population: As the variation in the population increases, sample size
increases.
•
Desired confidence level: As the desired confidence level increases, the required
sample size increases.
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•
Tolerable and expected misstatement: As tolerable misstatement increases, sample
size decreases, while an increase in expected misstatement results in an increase in sample
size.
9-8
The AICPA’s audit guide describes two acceptable methods of projecting the amount of
misstatement found in a non-statistical sample, ratio estimation and difference estimation. Ratio
estimation projects the amount of misstatement by dividing the amount of misstatement by the
percentage of the euros of the population included in the sample. Difference estimation projects
the average misstatement found in the sample to the population.
These two methods of projecting misstatements give identical results if the sample
includes the same proportion of items in the population as the proportion of the population’s
recorded amount included in the sample. If the proportions are different, the auditor chooses
between the two methods on the basis of his or her understanding of the magnitude and
distribution of misstatements in the population. If the auditor expects that the amount of
misstatement relates closely to the size of the item, the first method should be used. If the
auditor expects the misstatements to be relatively constant for all items in the population, the
second method should be used.
The advantages and disadvantages of classical variables sampling are:
9-9
Advantages:
•
When the auditor expects a large number of differences between book and audited
values, classical variables sampling will normally result in a smaller sample size than MUS.
•
Classical variables sampling techniques are effective for both overstatements and
understatements. No special evaluation considerations are necessary if the sample data
include both types of misstatements.
•
The selection of a zero balance generally does not require special sample design
considerations since the sampling unit will not be an individual euro but rather an account, a
transaction, or a line item.
Disadvantages:
•
In order to determine sample size, the auditor must estimate the standard deviation of
the audited value or differences.
•
If few misstatements are detected in the sample data, the true variance tends to be
underestimated and the resulting projection of the misstatements to the population is not
likely to be reliable.
9-10 The decision that the evidence supports or does not support the account balance using
classical variables sampling is made by determining if the recorded book value is included
within the confidence interval. If the confidence interval includes the book value, the evidence
supports the conclusion that the account is fairly stated. If the book value is not included in the
confidence interval, the evidence does not support the conclusion that the account is fairly
stated.
Solutions to Problems
9-11 a.
The advantages of MUS over classical variables sampling are as follows:
•
MUS sampling is generally easier to use than is classical variables sampling.
•
The calculation of sample size in a MUS sample is not based on an estimate of
the standard deviation in the population.
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MUS sampling in conjunction with probability-proportional-to-size selection
results in a stratified sample.
•
Individually significant items are automatically identified.
•
If no misstatements are expected, MUS will usually result in a smaller sample
size than classical variables sampling.
•
b.
Using Table 8-7 in the text with a desired confidence level = 95%, tolerable
misstatement = 5% (€15,000 ÷ €300,000), and expected misstatement = 2%, (€6,000 ÷
€300,000) sample size is equal to 181 items. The sampling interval is €1,657 (€300,000 ÷ 181).
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c.
The total projected misstatement for the three misstatements identified is calculated by
first computing the tainting factor as follows:
Misstatement
Number
Book
Value
Audit
Value
1
$€400
$€320
2
500
0
3
3,000
2,500
Tainting
Factor
.20
1.00
Not applicable, since book value
exceeds sampling interval.
The upper misstatement limit is calculated as follows:
$€1,657
1,657
1,657
Projected
Misstatement
(column 2 x
3)
NA
1,657
331
95% Upper
Limit Increment
(from Table 89*)
3.0
1.7 (4.7-3.0)
1.5 (6.2-4.7)
Upper
Misstatement
(column 2 x 3 x
5)
$€4,971
2,817
497
1,657
NA
NA
500
Misstatement
Number
Tainting
Factor
Sampling
Interval
Basic Precision
2
1
Add
misstatements
detected in
logical units
greater than the
sampling
interval:
1.0
1.0
.20
NA
Misstate
ment 3
Upper Misstatement Limit
NA—Not Applicable
* Using sample size 100, see footnote iii in chapter 9.
$€8,785
Since the UML (€8,785) is less than the TM (€15,000), the evidence supports the fair
presentation of the account balance.
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9-12 a.
Using Table 8-7 with a desired confidence level = 95% (risk of incorrect
acceptance = 5%), tolerable misstatement = 5% (€212,500 ÷ €4,250.000), and expected
misstatement = 1.5% (€63,750 ÷ €4,250,000), sample size is equal to 124. The sampling
interval is €34,274 = €4,250,000 ÷124).
b.
The upper misstatement limit is calculated as follows:
Overstatement Errors
Error
Number
Book Value
Audit Value
Tainting Factor
1
6,000
2,000
.667
2
24,000
20,000
.167
3
140,000
65,000
Not applicable, since the book
value exceeds the sampling
interval
Error Number
Tainting
Factor
Sampling
Interval
Projected
Misstatement
(column 2 x 3)
Basic Precision
1
2
Add misstatements
detected in logical
units greater than
the sampling
interval:
1.0
.667
.167
$€34,274
34,274
34,274
NA
34,274
Error 3
Upper
Misstatement
(column 2 x 3
x 5)
NA
22,861
5,724
95% Upper
Limit
Increment
(from Table
8-9*)
3.0
1.7 (4.7-3.0)
1.5 (6.2-4.7)
NA
NA
75,000
$€102,822
38,864
8,586
Upper Misstatement Limit
$€225,272
NA—Not Applicable
* Using sample size 100, see footnote iii in chapter 9.
Since the UML (€225,272) is more than the TM (€212,500), Zhu can not accept the inventory
account as being fairly stated since there is only a 5 per cent risk that the account contains a
misstatement greater than €212,500.
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9-13 a.
Using Table 8-7 with a desired confidence level of 95% (risk of incorrect
acceptance = 5%), tolerable misstatement = 4% (€360,000 ÷ €9,000,000), and expected
misstatement = 1% (€90,000 ÷ €9,000,000), sample size is equal to 156. The sampling interval
is €57,692 (€9,000,000 ÷156).
b. The upper misstatement limit is calculated as follows:
Overstatement Errors
Error
Number
Book
Value
Audit
Value
Tainting Factor
1
10,000
7,500
.25
2
9,000
6,000
.33
3
60,000
0
Not applicable, since the book value exceeds the
sampling interval
4
800
640
.20
Error Number
Tainting
Factor
Sampling
Interval
Projected
Misstatement
(column 2 x 3)
Basic Precision
2
1
4
Add misstatements
detected in logical
units greater than
the sampling
interval:
1.0
.33
.25
.20
$€57,692
57,692
57,692
57,692
NA
57,692
Error 3
Upper
Misstatement
(column 2 x 3
x 5)
NA
19,038
14,423
11,538
95% Upper
Limit
Increment
(from Table
8-9*)
3.0
1.7 (4.7-3.0)
1.5 (6.2-4.7)
1.4 (7.6-6.2)
NA
NA
60,000
Upper Misstatement Limit
NA—Not Applicable
* Using sample size 100, see footnote iii in chapter 9.
$€173,076
32,365
21,635
16,153
$€303,229
Since the UML (€303,229) is less than the tolerable misstatement (€360,000), Nancy Van Pelt
can accept the inventory account as being fairly stated since there is only a 5 per cent risk that
the account contains a misstatement greater than €360,000.
The calculation of the adjustment for the understatement errors is as follows:
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Understatement Errors
Error
Number
Value
Book
Value
Audit
Factor
Tainting
5
6,000
6,500
-.083
6
750
800
-.067
Adjustment for Understatement Errors
Tainting
Factor
Samplin
Projected
Misstatem
g
Interval
ent
-.083
57,692
-4,788
-.067
57,692
-3,865
Adjustment to UML
-8,653
9-14 a.
Remove the 10 accounts (€750,000) from the sampling population because they
will be the subject of 100% testing. Sample size is calculated as follows:
' !4,750,000 $
Sample Size = %
" ! 1.2 = 37
& !155,000 #
b.
The projected misstatement for the accounts receivable account is:
Amount of
Misstatement
Percentage of
Strata Sampled
Projected
Misstatement
>€50,000
$€ 3,500
100%
$€ 3,500
>€5,000
15,250
910,000 ÷ 3,000,000 =
.303
50,330
<€5,000
1,550
70,000 ÷1,750,000 = .04
38,750
Str
ata
Projected misstatement
$€ 92,580
Since the projected misstatement (€92,580) is significantly greater than the expected
misstatement (€60,000), Judd should conclude that there is an unacceptably high risk that the
true misstatement exceeds the tolerable misstatement.
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a.
9-15
The calculation of the sample size for Paonessa’s test of Cougar Goldust is:
2
& 4,000 x 1.64 x 25 #
=$
! = 43
35
,
000
10
,
000
"
%
Sample size
.03, round to 44
b.
The calculation of the sample results is as follows:
The calculation of the mean misstatement per sampling item is:
=
Mean Misstatement per sampling item
Total audit difference
400
= 4
=
100
Sample Size
Thus, the average misstatement in a bin based on the sample data is an overstatement of 4
ounces. Next, the mean misstatement is projected to the population:
Projected population = Population size x
Misstatement
16,000 ounces
= 4000
Mean misstatement
per sampling item
x
4
Next compute the point estimate. In this case we are working with recorded weight in ounces
rather than euros
Point estimate = Book value (in ounces) + Projected population
misstatement
684,000 ounces
=
700,000
-
16,000
Thus, the point estimate for the audit value is 684,000 ounces. The achieved precision is
determined by first calculating the standard deviation and then using the equation shown below,
using the Z value for the risk of incorrect acceptance.
SD =
(
Total squared audit difference - sample size x mean difference per sampling item 2
sample size - 1
SD =
17,856 - 100 (4 )2
= 12.81
100 - 1
Confidence bound = N Z IA
SD
n
= 4,000 (1.64 )
12.81
100
= 8,403
where N = population size
n = sample size
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For Cougar Goldust, the confidence bound is 8,403 ounces and the confidence interval is
calculated as follows:
Confidence interval = Population point estimate + Confidence bound
=
684,000
+
8,403
Thus, the Confidence Interval has a lower limit of 675,597 ounces and an upper limit of 692,403
ounces. Since the perpetual account amount of 700,000 ounces does not lie inside the
precision interval, the sample evidence suggests that the perpetual records are not fairly stated
at a 5 per cent risk of incorrect acceptance.
The calculation of the sample results for Hipp Supply Company is as follows:
9-16
The calculation of the mean misstatement per sampling item is:
=
Mean Misstatement per sampling item
Total audit difference
481
= 4.81
=
100
Sample Size
Thus, the average misstatement in a bin based on the sample data is an overstatement of
€4.81. Next, the mean misstatement is projected to the population and a population point
estimate is determined as follows:
Projected population = Population size x
misstatement
=
€4,618
960
Point estimate = Book value
€92,882
=
€97,500
+
Mean misstatement
per sampling item
x
4.81
Projected population misstatement
-
4,618
Thus, the point estimate for the audit value is €92,882. The achieved precision is determined by
first calculating the standard deviation and then using the equation shown below, using the Z
value for the risk of incorrect acceptance.
(
SD =
Total squared audit difference - sample size x mean difference per sampling item 2
sample size - 1
SD =
8,895 - 100 (4.81)2
= 8.15
100 - 1
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Confidence bound = N Z IA
SD
n
= 960(1.28 )
8.15
100
= 1,001
where N = population size
n = sample size
For Hipp Supply Company, the confidence bound is €1,001 and the confidence interval is
calculated as follows:
Confidence interval = Population point estimate + Confidence bound
= €92,882
+
1,001
Thus, the confidence interval has a lower precision limit of €91,881 and an upper limit of
€93,883. Since the book value of €97,500 does not lie inside the precision interval, the sample
evidence suggests that the inventory is not fairly stated at a 10 per cent risk of incorrect
acceptance.
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Solution to Discussion Cases
9-17 The incorrect assumptions, statements, and inappropriate applications of sampling are
as follows:
•
Classical variables sampling is not designed for tests of controls.
•
MUS sampling uses each euro in the population, not each account, as a separate
sampling unit.
•
MUS sampling is not efficient if many misstatements are expected because the
sample size can become larger than the corresponding sample size for classical variables
sampling as the expected amount of misstatement increases.
•
Each account does not have an equal chance of being selected; the probability of
selection of the accounts is proportional to the account’s euro amount.
•
MUS sampling requires special consideration for negative (credit) balances.
•
Tolerable misstatement was not considered in calculating sample size.
•
Expected misstatement was not considered in calculating sample size.
•
The standard deviation of the euro amounts is not required for MUS sampling.
•
The three selected accounts with insignificant balances should not have been
ignored or replaced with other accounts.
•
The account with the €1,000 difference (recorded amount of €4,000 and audited
amount of €3,000) was incorrectly projected as a €1,000 misstatement; the projected
misstatement for this difference was actually €2,500 (€1,000/€4,000 x €10,000 sampling
interval).
•
The difference in the understated account (recorded amount of €1,900 and audited
amount of €2,000) should not have been omitted from the calculation of projected
misstatement.
•
The reasoning (the comparison of projected misstatement with the allowance for
sampling risk) concerning the decision that the receivables balance was not overstated was
erroneous.
9-18 a. While Doug’s selection method is not random, judgmentally ‘targeting’ items for
testing is acceptable under auditing standards and it may be preferable if there is reason to
think some balances are more likely misstated than others. Doug’s reasoning for selection
seems reasonably sound.
b. Because the items selected were not identified randomly, Doug cannot use statistical
sampling methods to quantify sampling risk or evaluate his results. His ‘sample’ accounts for
66% (€720,000/€1,090,000) of ending inventory and even though it isn’t technically appropriate
to project the results from the ‘sample’ we can use our understanding of projection to inform our
judgment regarding the sufficiency of the evidence. Projected misstatement using ratio
estimation would be €121,111 (€80,000/€720,000 x €1,090,000) which is well below tolerable
misstatement of €250,000 (€500,000 x 50 per cent).
Doug based his selection on the items that were most risky or most likely to be misstated.
Assuming his was successful at identifying the riskiest items and the fact that he obtained
relatively high coverage (the remaining items account for only 44%) and that they are less likely
to contain misstatement, it appears reasonable to conclude he has sufficient evidence to
consider the balance fairly stated. It might be reason to assume that the account is not
materially misstated.
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CHAPTER 10
AUDITING THE REVENUE PROCESS
Answers to Review Questions
10-1 As a general rule revenue is recognized when the earnings process is complete.
International Accounting Standard (IAS) 18 Revenue states that revenue is recognised when it
is probable that future economic benefits will flow to the entity and these benefits can be
measured reliably. For example, revenues from the sale of goods are recognised once delivery
has taken place, the risk has been transferred, and the entity has established a receivable due
by customer. IAS 18 provides the following criteria for revenue recognition:
• The entity has transferred to the buyer the significant risks and rewards of ownership of
the goods.
• The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold.
• The amount of revenue can be measured reliably.
• It is probable that the economic benefits associated with the transaction will flow to the
entity.
• The costs incurred or to be incurred in respect of the transaction can be measured
reliably.
10-2 The credit authorization function has the responsibility for monitoring customer
payments. An aged trial balance of accounts receivable should be prepared and reviewed by
the credit authorization function. Payment should be requested from customers who are
delinquent in making payments for goods or services. The credit function is usually responsible
for preparing a report of customer accounts that may require write-off as bad debts. However,
the final approval for writing off an account should come from an officer of the company who is
not responsible for credit or collections.
10-3 Industry-related factors such as the profitability and health of the industry in which the
entity operates, the level of competition within the industry, and the industry’s rate of
technological change affect the potential for misstatements in the revenue process. The level of
governmental regulation (e.g. by a medicine control agency) within the industry may also affect
sales activity. Finally, most countries have consumer protection legislation that may affect
product warranties, returns, financing and product liability. Such industry-related factors directly
impact the auditor’s inherent risk assessment for the authorization and valuation audit
objectives.
The presence of misstatements in previous audits is a good indicator that misstatements are
likely to be present during the current audit. If misstatements were present in previous audits,
the auditor should assess inherent risk to be high.
10-4 The auditor needs to obtain the following knowledge for each major class of transactions
in the revenue process when performing a walkthrough:
• How sales, cash receipts, and sales returns and allowances transactions are initiated.
• The accounting records, supporting documents and accounts that are involved in
processing sales, cash receipts, and sales returns and allowances transactions.
• The flow of each type of transaction from initiation to inclusion in the financial
statements, including computer processing of the data.
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The process used to prepare estimates for accounts such as the allowance for
uncollectible accounts and sales returns.
•
10-5 Two important controls for processing of credit memoranda for sales returns and
allowances transactions are: (1) each credit memorandum should be approved by someone
other than the individual who initiated it and (2) a credit for returned goods should be supported
by a receiving document indicating that the goods have been returned.
10-6
The analytical procedures that can be used to test revenue-related accounts and the
possible misstatements that can be detected by each analytical procedure are (also see
Table 10-9):
Analytical Procedure
Possible Misstatement Detected
Revenue:
Comparison of gross profit percentage by
product line with previous years’ and/or industry
data.
Unrecorded (understated) revenue
Fictitious (overstated) revenue
Changes in pricing policies
Product-pricing problems
Comparison of reported revenue to budgeted
revenue.
Accounts
Receivable,
Uncollectible
Accounts,
Expense:
Allowance
for
and
Bad-Debt
Comparison of receivables turnover and days
outstanding in accounts receivable to previous
years’ and/or industry data.
Under- or overstatement of allowance
for uncollectible accounts and bad-debt
expense
Comparison of aging categories on aged trial
balance of accounts receivable to previous
years.
Comparison of bad-debt expense as a
percentage of revenue to previous years’ and/or
industry data.
Comparison of the allowance for uncollectible
accounts as a percentage of accounts receivable
or credit sales to previous years’ and/or industry
data.
Examination of large customer accounts
individually and comparison to previous year.
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Sales Returns and Allowances, and Sales
Commissions:
Comparison of sales returns as a percentage of
revenue to previous years’ and/or industry data.
Underreturns
or
overstatement
of
sales
Comparison of sales discounts as a percentage
of revenue to previous years’ and/or industry
data.
Under- or
discounts
overstatement
of
sales
Estimation of sales commissions expense by
multiplication of net revenue by the average
commission rate and comparison to recorded
sales commission expense.
Under- or overstatement of sales
commission expense and related
accrual
10-7 The auditor verifies the accuracy of the aged trial balance using the following steps.
First, a copy of the aged trial balance of accounts receivable is obtained from the client and the
total balance is compared to the accounts receivable general ledger balance. Second, a
sample of customer accounts selected for proper inclusion in the aged trial balance. For each
selected customer account, the auditor traces the customer’s balance back to the subsidiary
ledger detail and verifies the total amount and the amounts included in each column for proper
aging. These two steps mainly describe a manual approach to testing accuracy. A second
approach would involve the use of computer-assisted audit techniques. If the general controls
over IT are adequate, the auditor can use a generalized audit software package to perform the
steps described in the first approach to examine the accuracy of the aged trial balance
generated by the client’s accounting system.
10-8 Three factors that affect the reliability of accounts receivable confirmations are:
• The type of confirmation request.
• Prior experience on the client or similar engagements.
• The intended respondent.
The types of confirmations include positive and negative confirmations. Generally, positive
confirmations are considered more reliable because the recipient is required to respond to the
auditor regardless of whether a misstatement exists or not. Prior experience with the client in
terms of confirmation response rates, misstatements identified, and the accuracy of returned
confirmations should be considered when assessing the reliability of accounts receivable
confirmations. For example, if response rates were low in prior audits, the auditor might
consider obtaining evidence using alternative procedures. Finally, the intended respondents to
accounts receivable confirmations may vary from individuals with little accounting knowledge to
highly qualified accounting personnel in large companies. The auditor should consider the
respondent’s competence, knowledge, ability and objectivity when assessing the reliability of
confirmation requests.
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10-9 A positive accounts receivable confirmation requests that the customer indicate whether
or not it is in agreement with the amount due to the client stated in the confirmation. Thus, a
response is required regardless of whether the customer believes that the amount is correct or
incorrect. A negative confirmation requests that the customer respond only when it disagrees
with the amount due to the client.
Positive confirmations are generally used when an account contains large individual balances or
if errors are anticipated because control risk was judged to be high. Negative confirmation
requests are used when there are a large number of accounts with small balances, control risk
is assessed to be low, and the auditor believes that the customers will devote adequate
attention to the confirmation.
10-10 Other types of receivables that the auditor should examine include:
•
Receivables from officers and employees.
•
Receivables from related parties.
•
Notes receivable.
The auditor would confirm and evaluate each type of receivable for collectibility. The
transactions that result in receivables from related parties are examined to determine if they
were at ‘arm’s length.’ Notes receivable would also be confirmed and examined for repayment
terms and whether interest income has been properly recognized.
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Solutions to Problems
10-11
1.
IAS 18 states that revenue is recognized when the entity has transferred to the
buyer the significant risks and rewards of ownership of the goods. The assessment
of when an entity has transferred the significant risks and rewards of ownership to
the buyer requires an examination of the circumstances of the transaction. In
Thompson’s business practice of requiring a written sales agreement for this class
of customer, persuasive evidence of an arrangement would require properly
authorized personnel of the customer have executed final agreement. Bayonne’s
execution of the sales agreement after the end of the quarter causes the transaction
to be considered a transaction of the subsequent period by accounting standards
such as IAS 18.
2.
Provided that other criteria for revenue recognition are met, Best Products should
recognize revenue from sales of its layaway program upon delivery of the
merchandise to the customer. Until then, the amount of cash received should be
recognized as a liability. Because Best Products retains the risk of ownership of the
merchandise, receives only a deposit from the customer, and does not have an
enforceable right to the remainder of the purchase price, accounting standards such
as IAS 18 would not allow recognition of the revenue.
3.
It would not be appropriate for Dave’s to recognize the membership fees as revenue
upon billing or receipt of initial fee with a corresponding accrual of estimated costs to
provide the membership services. This conclusion is based on Dave’s remaining
and unfulfilled contractual obligation to perform services throughout the remaining
period. Therefore, the earnings process, irrespective of whether a cancellation
clause exists, is not complete. Additionally, the ability of the member to receive full
refund of the membership fee up to the last day of the membership term raises
uncertainty as to whether the fee is fixed or determinable at any point before the end
of the term.
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10-12 Johnson Coat Outlet
Internal Control Questionnaire
Shipments
Question
Yes
1.
Are shipping documents prepared from sales orders approved
in accordance with management’s authorization?
2.
Are shipping documents prenumbered?
3.
Are shipping documents periodically accounted for?
4.
Are shipping documents recorded in a register, log, or file?
5.
•
•
Are copies of shipping documents forwarded to the
Billing Department?
Inventory Control Department?
6.
Do shipping documents include cross-reference to sales
orders; customer identity and address; description and quantities of
goods shipped; date; and other details?
7.
•
•
•
•
•
•
•
Is the shipping function independent of
Sales orders?
Credit approval?
Billing and accounts receivable?
Cash receipts?
Warehouse?
Receiving?
Inventory control?
8.
Is access to merchandise restricted and controlled within the
shipping department?
9.
Are type and quantities of goods withdrawn and packed for
shipping verified by independent counts?
10. Are receipts from carriers obtained and filed?
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10-13 The weaknesses in Newton Hardware’s internal controls include the following:
Warehouse clerk:
• Initiates posting to inventory records by preparation of shipping advice.
• Releases merchandise to customers before proper approvals of customers’ credit.
• Does not retain a copy of the shipping advice for comparison with receipt from carrier.
Bookkeeper A:
• Authorizes customers’ credit and prepares source documents for posting to customers’
accounts.
• Prepares invoices without notice that the merchandise was actually shipped and the
date it was shipped.
• Authorizes write-offs of customer accounts receivable and authorizes customers’ credit.
Collection clerk:
• Receives directly and records customers’ cheques.
• Does not deliver cheques excluded from the deposit to an employee independent of the
bank deposit for review and disposition.
• Initiates posting of receipts to subsidiary accounts receivable ledger and has initial
access to cash receipts.
• Does not deposit cash receipts promptly.
• Reconciles bank statement and has initial access to cash receipts.
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10-14 The following weaknesses in the existing informal control system over cash admission
fees should be identified by Smith along with the related recommendation for
improvement:
Weakness
Recommendation
2.
There is no segregation of duties
between persons responsible for collecting
admission fees and persons responsible
for authorizing admission.
2.
One clerk (the collection clerk) should
collect admission fees and issue prenumbered
tickets. The other clerk (the admission clerk)
should authorize admission upon receipt of
the ticket or proof of membership.
3.
An independent count of paying
patrons is not made.
3.
The admission clerk should retain a
portion of the prenumbered admission ticket
(admission ticket stub).
4.
There is no proof of accuracy of
amounts collected by the clerks.
4.
Admission ticket stubs should be
reconciled with cash collected by the treasurer
each day.
5.
Cash receipts
promptly prepared.
are not
5.
The cash collections should be
recorded by the collection clerk daily on a
permanent record that will serve as the first
record of accountability.
6.
Cash receipts are not promptly
deposited.
Cash should not be left
undeposited for a week.
6.
Cash should be deposited at least
once each day.
7.
There is no proof of accuracy of the
amounts deposited.
7.
Authenticated deposit slips should be
compared with daily cash collection records.
Discrepancies
should
be
promptly
investigated and resolved. In addition, the
treasurer should establish a policy that
includes an analytical review of cash
collections.
8.
There is no record of the internal
accountability for cash.
8.
The treasurer should issue a signed
receipt for all proceeds received from the
collection clerk. These receipts should be
maintained and periodically checked against
cash collection and deposit records.
records
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10-15
a.
b.
c.
d.
e.
1
3
4
6
5
10-16 In addition to sending second requests, Signoff-on can perform the following audit
procedures:
• Examination of subsequent cash receipts.
• Examination of the customer orders, shipping documents, and duplicate sales invoices.
• Examination of other client documentation.
10-17 The working paper contains the following deficiencies:
• The working paper was not initialled and dated by the audit assistant.
• Negative confirmations not returned cannot be considered to be accounts ‘confirmed
without exception.’
• The two positive confirmations that were sent but were unanswered are not accounted
for.
• There is no documentation of alternate procedures, possible scope limitation, or other
working paper reference for the six accounts selected for confirmation that the client
asked the auditor not to confirm.
• The euro amount and percentage of the six accounts selected for confirmation that the
client asked the auditor not to confirm is omitted from the ‘Euros’ columns for the ‘Total
selected for testing.’
• The ‘Euros-Per cent’ for ‘Confirmation Requests-Negatives’ is incorrectly calculated at
10 per cent.
• There is no indication of follow-up or cross-referencing of the account confirmed-relatedparty transaction.
• The tick mark ‘‡’ is used but is not explained in the tick mark legend.
• There is no explanation for proposed disposition of the ten differences aggregating
€12,000.
• The overall conclusion reached is not appropriate.
• There is no notation that a projection from the sample to the population was made.
• There is no reference to second requests.
• Cross-referencing is incomplete, such as the eighteen ‘Differences reported and
resolved, no adjustment’ and ‘Confirmation Requests’ to the confirmation control
schedule.
10-18 In order to determine whether lapping exists, Stanley would test the aging of accounts
receivable and then:
• Mail positive accounts receivable confirmation requests directly to all customers with old
balances.
• Investigate all exceptions noted on confirmations.
• Obtain authenticated deposit slips directly from the bank.
• Compare individual customers’ names, dates, and amounts shown on the customer’s
remittance advices with the names, dates, and amounts recorded in the cash receipts
journal, individual customer ledger accounts, and deposit slips (if practicable).
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•
•
•
•
•
Verify the propriety of noncash credits to accounts receivable (e.g. sales discounts,
sales returns, bad-debt write-offs).
Perform a surprise inspection of deposits.
Foot the cash receipts journal, the customers’ ledger accounts, and the accounts
receivable control account.
Reconcile the total of the individual customers’ accounts with the accounts receivable
control account.
Compare information in copies of monthly customers’ statements with information in
customers’ ledger accounts.
10-19 In evaluating proper sales cutoff, three points should be noted: (1) The book-to-physical
adjustment has already been made by the client, (2) all sales are made FOB shipping (title
passes to the customer at the time the goods are shipped), and (3) goods on hand on 31
January are included in the physical inventory.
a.
Since the goods were shipped on 31 January, they were included in the physical
inventory at the end of the fiscal year. Since the sale should be recognized in the
current fiscal year, the following adjustment is necessary:
Cost of merchandise sold
Inventory
2,000
2,000
b.
This sale is properly recorded as a current-fiscal-year sale. However, the auditor
should inquire as to why there was such a delay in processing the sales invoice.
c.
The sale is properly recorded in the current year.
d.
Since the goods were not shipped until 3 February, they would have been included
in the physical inventory. However, the sale was recorded as a current-fiscal-year
sale. Therefore, the sale should be reversed since title has not passed to the
customer. The following adjusting entry should be made:
Sales
Accounts receivable
e.
4,000
4,000
Since this transaction is a shipment of merchandise to a consignee, no sale should
be recognized. Since the goods were not on hand on 31 January, the following entry
is necessary:
Sales
Inventory
Accounts receivable
Cost of merchandise sold
f.
10,000
5,600
10,000
5,600
This sale should be recorded in the current fiscal year. Since the merchandise was
shipped on 30 January, it was not included in the physical inventory. Thus the
following adjusting entry is necessary:
Accounts receivable
Sales
6,000
6,000
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g.
This transaction is correctly recorded as a sale in the next period.
h.
Since the merchandise was shipped on 31 January, it should be recorded as a sale
in the current fiscal year. It was also included in the physical inventory because it
was on hand on that date. Thus the following adjusting entry is necessary:
Accounts receivable
Cost of merchandise sold
Sales
Inventory
8,000
5,500
8,000
5,500
Solution to Discussion Case
10-20 a.
Friendly Furniture carried insurance coverage for property loss at replacement
value and business interruption insurance for lost production.
The first issue that needs to be considered is the timing of recognition for some or all of the
insurance proceeds that Friendly Furniture is entitled to and expects to receive. The company
will likely want to recognize the estimated proceeds from insurance coverage at the earliest
possible date to offset losses, if any, from the destruction of fixed assets and inventory as well
as from lost production.
There are a number of points in time when the insurance proceeds may be recognized. The
most conservative approach--the one likely to be least favoured by the company--would be
when the proceeds are received. The other extreme would be recognition of the insurance
proceeds before verification of coverage or admission of liability by the insurance carrier.
There are two other alternatives: (1) recognition when the company has been able to determine
that coverage exists and has been able to develop a minimum estimate of the amount to be
recovered or (2) when the insurance carrier has admitted liability. A decision as to which of
those alternatives should be used needs to be based on the company’s ability to estimate the
proceeds as reliably as possible. If the insurance company has admitted to a liability, Friendly
Furniture would have a good basis for recognizing the minimum amounts subject to an
evaluation of the reliability of the estimates and the probability of collection.
One possible answer is to recognize insurance proceeds (a receivable from the insurance
company) in Friendly Furniture’s financial statements at 30 June in the following manner: credit
a portion of business interruption insurance to cost of sales and recognize in other income a
gain that consists of the estimated minimum or expected amount that the replacement cost
insurance proceeds exceed the net book value of equipment and inventory destroyed and
unallocated proceeds from business interruption insurance.
b.
The auditor can perform the following procedures to support the amount recorded for the
receivable:
• Examine the inventory records, including the perpetual and physical inventory, to
determine the cost of the inventory destroyed by the flood.
• Examine the appraisal reports to test the fair market value of the inventory destroyed.
• Examine the property, plant, and equipment subsidiary records to determine the cost
(book value) of the equipment destroyed.
• Examine the appraisal reports to test the fair market value of the equipment destroyed.
• Examine the client’s and insurance company’s calculation of the amount of income to be
recognized as a result of the business interruption.
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Solution to Internet Assignment
10-21 It is difficult to get information directly on some of EarthWear’s competitors. Your search
could be for financial statements of catalogue sportswear retailers in your home country or in
other countries. For example, Eddie Bauer is part of The Spiegel Group. The Spiegel Group’s
annual report states that revenue from catalogue and e-commerce sales is recognized at time of
shipment. They also disclose that they reserve for returns at the time of sale based on
projected returns. Timberland reports that it recognizes revenue at the time of shipment, but
there is no disclosure on returns.
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CHAPTER 11
AUDITING THE PURCHASING PROCESS
Answers to Review Questions
11-1
1.
2.
3.
11-2
Expenses can be classified into three categories:
Product costs are expenses that can be matched directly with specific transactions or
events and are recognized upon recognition of the revenues. An example of a
product cost would be the expensing of inventory through cost of goods sold.
Period costs are expenses that are recognized during the period in which cash is
spent or liabilities incurred for goods and services that are used up at that time or
shortly thereafter. Such expenses cannot be directly related to specific transactions
and are assumed to provide no future benefit. Examples of such expenses are
administrative salaries, rent expense, and interest expense.
Some expenses are allocated by systematic and rational procedures to the periods
during which the related assets are expected to provide benefits. Depreciation of
plant and equipment is an example of such an expense.
The three types of transactions that are processed through the purchasing process are:
• Purchase of goods and services for cash or credit.
• Payment of the liabilities arising from such purchases.
• Return of goods to suppliers for cash or credit.
The more common accounts affected by each major type of transaction are:
Purchase transaction:
• Accounts payable
• Inventory
• Purchases or cost of goods sold
• Various asset and expense accounts
Cash disbursement transaction:
• Cash
• Accounts payable
• Cash discounts
Purchase return transaction:
• Purchase returns
• Purchase allowances
• Accounts payable
©The McGraw-Hill Companies, Inc., 2006
Solutions Manual, Chapter 11
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11-1
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11-3 A purchase requisition is a request for goods and services by an authorized individual or
department within the entity. A purchase order contains the description, quality, quantity and
other information on the goods and services being purchased. A receiving report is used to
record the receipt of goods. A vendor invoice is the bill from the vendor that includes the
description and quantity of the goods shipped or services provided, the price including freight,
the terms of trade including cash discounts, and the date billed. A voucher is a document that is
frequently used by entities to control the payment of acquired goods and services.
An entity would combine all these documents into a ‘voucher packet’ because such a
packet would contain all the information on a particular purchase transaction. If there are
questions about the transaction at a later time, the entity can obtain access to all the documents
and information more easily.
11-4 The key segregation of duties and the errors or fraud that can occur if they are not
present are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The purchasing function should be
segregated from the requisitioning and
receiving functions.
Theft of goods and possible payment for
unauthorized purchases.
The invoice-processing function should
be segregated from the accounts
payable function.
Overpayment for goods and services or
theft of cash.
The disbursement function should be
segregated from the accounts payable
function.
Theft of cash.
The accounts payable function should
be segregated from the general ledger
function.
A defalcation that would normally be
detected by reconciling subsidiary records
with the general ledger control account.
11-5 Two inherent risk factors that directly affect the purchasing process are (1) industryrelated factors, and (2) misstatements detected in prior audits.
If the entity deals with a large number of vendors and prices tend to be relatively stable, there is
less risk that the entity’s operations will be affected by raw-material shortages or that production
costs will be difficult to control. However, if an entity is dependent on a single vendor to supply
a critical component and the vendor is unable to provide the component, the entity may suffer
production shortages and shipping delays that significantly affect financial performance.
Additionally, industries that use commodities such as oil, coal and precious metals may be
subject to both shortages and price instability that significantly affect their financial results.
The presence of misstatements in previous audits is a good indicator that misstatements are
likely to be present during the current audit. If misstatements were present in previous audits,
the auditor should assess inherent risk to be high.
11-6 The following controls and related tests are utilized to ensure that the occurrence,
authorization, valuation, and classification objectives are met for purchase transactions:
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Assertions
Control Activities
Tests of Controls
Occurrence
Segregation of duties
Observe and evaluate
segregation of duties.
Purchase not recorded
without
approved
purchase
order
and
receiving report
Test of a sample of vouchers for
the presence of an authorized
purchase order and receiving
report; if IT application, examine
application controls.
Accounting for numerical
sequences of receiving
reports and vouchers
Review
and
test
client’s
procedures for accounting for
numerical sequence of receiving
reports and vouchers;
if IT
application, examine application
controls.
Cancellation
documents
Examine paid vouchers and
supporting
documents
for
indication of cancellation.
Review client’s monetary limits
authorization for acquisitions.
Authorization
Completeness
of
Approval of acquisitions
consistent with the client’s
authorization
monetary
limits
proper
Approved
purchase
requisitions and purchase
orders
Examine purchase requisitions or
purchase orders for proper
approval; if IT is used for
automatic ordering, examination of
application controls.
Competitive
bidding
procedures followed
Accounting for numerical
sequences of receiving
reports and vouchers
Review client’s competitive bidding
procedures.
Review
and
test
client’s
procedures for accounting for
numerical sequence of receiving
reports and vouchers; if IT
application, examine application
controls.
Receiving report matched
to vendor invoices and
entered in purchases
journal
Trace a sample of receiving
reports to their respective vendor
invoices and vouchers.
Trace a sample of vouchers to the
purchases journal.
11-7 When the information system is highly computerized, CAATs can be used to test
numerous controls in the purchasing process. For example, a generalized audit software
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package can be used to account for the numerical sequence of purchase orders, receiving
reports and vouchers. Another example involves the use of a CAAT to test programmed
controls over approval of purchase orders when IT is used for automatic ordering (e.g.
electronic data interchange).
11-8 The analytical procedures that can be used to test accounts payable and accrued
expenses and the possible misstatements that can be detected by each analytical procedure
are:
Substantive Analytical Procedure
Possible Misstatement Detected
Compare
payable
turnover
and
days
outstanding in accounts payable with previous
years’ and industry data.
Under- or overstatement of liabilities and
expenses
Compare current-year balances in accounts
payable and accruals with prior years’
balances.
Under- or overstatement of liabilities and
expenses
Compare amounts owed to individual vendors
in the current year’s accounts payable listing to
amounts owed in prior years.
Under- or overstatement of liabilities and
expenses
Compare purchase returns and allowances as
a percentage of revenue or cost of sales to
prior years’ and industry data.
Under- or overstatement of purchase returns
11-9 The following audit procedures may be used as part of the search for unrecorded
liabilities:
• Inquiry of management about control activities used to identify unrecorded liabilities and
accruals at the end of an accounting period.
• Obtain copies of vendors’ monthly statements and reconcile the amount to client’s
accounts payable records.
• Confirm vendor accounts, including accounts with small or zero balances.
• Vouch large monetary items from the purchases journal and cash disbursements journal
for a limited time after year-end; examine the dates on each receiving report or vendor’s
invoice to determine if the liability relates to the current audit period.
• Examine the files of unmatched purchase orders, receiving reports and vendor invoices
for any unrecorded liabilities.
11-10 The following are examples of disclosures for the purchasing process and related
accounts:
• Payables by type (trade, officers, employee, affiliate, etc.).
• Short- and long-term payables.
• Long-term purchase contracts, including any unusual or adverse purchase
commitments.
• Purchases from and payables to related parties.
• Dependence on a single vendor or small number of vendors.
• Costs by reportable segment of the business.
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11-11 Accounts payable confirmations are generally used less frequently by auditors than
accounts receivable confirmations because the auditor can test accounts payable by examining
vendor invoices and monthly vendor statements. Since these documents originate from
sources external to the client, this evidence is viewed as reliable. Accounts payable
confirmations primarily provide evidence on completeness, while accounts receivable
confirmations primarily provide information on validity. When confirming accounts payable,
auditors generally use a form of positive confirmation referred to as a ‘blank or zero-balance’
confirmation. This type of positive confirmation does not state the balance owed. Instead, the
confirmation requests that the recipient fill in the amount or furnish other information. Both
positive and negative confirmations are used for accounts receivable. Lastly, accounts payable
confirmations are generally mailed at year-end rather than at an interim date because of the
auditor’s concerns about unrecorded liabilities. Accounts receivable confirmations are sent at
both dates.
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Solutions to Problems
11-12
Sommer Manufacturing
Internal Control Questionnaire
Purchases
Questions
Yes
1.
No
Are there written purchasing policies and procedures?
2.
Are purchase requisitions approved in accordance with
management’s authorization?
3.
Are purchases made from approved vendors?
4.
Are price quotations requested for purchases over an
established amount?
5.
Are purchase commitments documented on written purchase
order forms?
6.
Do purchase orders include adequate descriptions, terms and
instructions?
7.
Are purchase orders approved by authorized personnel before
issuance?
8.
Are prenumbered purchase order forms periodically accounted
for?
9.
Is a detailed listing of purchase orders maintained?
10.
Is the purchasing function independent of the receiving,
shipping, invoice-processing, and treasury functions?
11.
Are there adequate safeguards over unissued purchase order
forms?
12.
Are old items in the open-purchase-order file periodically
investigated?
13.
Are vendors notified of conflict-of-interest policies?
11-13 The internal control activities that most likely would provide reasonable assurance that
specific control objectives for the financial statement assertions regarding purchases and
accounts payable will be achieved are:
•
The purchasing, receiving and accounts payable functions are segregated.
Requisitioning Department:
• Proper authorization of requisitions by department head is required before purchase
orders are prepared.
• The requisitioning department head independently verifies the quantity and quality of the
goods received.
Purchasing Department:
• The purchasing department ensures that requisitions are within budget limits before
purchase orders are prepared.
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•
The adequacy of each vendor’s past record as a supplier is verified.
Receiving Department:
• Secure facilities limit access to the goods during the receiving activity.
• The receiving department makes a blind count of the goods received, independently of
any other department.
Accounts Payable Department:
• Requisitions, purchase orders and receiving reports are matched with vendor invoices
as to quantity and price.
• The accounts payable department recomputes the mathematical accuracy of each
invoice.
• The voucher register is independently reconciled to the control accounts monthly.
• All supporting documentation is required for payments and is made available to the
treasurer.
11-14 a.
The flowchart for Kida Company is shown on the following page:
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Kida Company - Special Ordering System
Receiving Department Accts. Payable Department
Purchasing Department
From Department
Head
Purchase
Requisition
Treasurer
A
Purchase3
order
See
Note A
Purchase
order
1
Purchase 2
order
To
vendor
See
Note D
To Dept.
Head
Purchase 3
order
Purchase 4
order
Note A: Buyers verify that the
purchaser is a department
Purchase 5
head. The buyer searches
order
vendor catalogues and calls
vendor for a quote. Vendor
is given a verbal order. A
prenumbered purchase order
is processed.
Note B: When the buyer is orally
informed by the Receiving Department
that the item has been received, the
purchase order is transferred from the
unfilled file to the filled file.
Note C: Once a month the buyer reviews
the unfilled file to follow up on and
expedite open orders.
Checks
Purchase 4
order
See
Note G
Unpaid
file
Purchase3
order
See
Note E
To
Requisitioning
Dept.
By due
date
A
See
Note F
Vendor
invoice
Checks
To
vendors
Daily
Checks
Unfilled
See Note C
Purchase 4
order
See
Note B
Filled
Note D: When equipment is
received, purchase order is
stamped and any differences
noted. Equipment sent to
Requisitioning Department.
Paid
file
Vendor
invoice
Note E: Matches vendor invoice with
purchase order and sets up a payable.
Note G: Checks sorted into
two groups. Checks under
$10,000 are machine
signed. Checks over
$10,000 are signed by the
treasurer or controlller.
Note F: Checks are prepared on due
date.
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b.
Kida Company’s major internal control weaknesses are:
Purchasing:
• The buyer does not verify that the department head’s request is within budget limitations.
• No procedures have been established to ensure that the best price is obtained. Largeeuro requisitions should be ordered after receiving quotes and/or sealed bids.
• Prior to placing an order, the buyer does not determine the adequacy of the vendor’s
past record as a supplier to Kida.
Receiving:
• Receiving clerk does not make blind counts for all special equipment or at least for largeeuro items.
• Written notice of equipment received is not sent to the purchasing department.
• Written notice of equipment received is not sent to accounts payable department.
Accounts Payable:
• The mathematical accuracy of the invoice is not recomputed.
• Invoice quantity is not compared with a report of quantity received.
• Notification of the acceptability of the equipment from the requisitioning department is
not obtained before the payable is recorded.
• No alphabetic file of vendors from which purchases are made is maintained.
Treasurer:
• Documentation supporting the cheques is not sent by the accounts payable Department
to the cashier in order for the cashier or treasurer to be assured that the cheque is for
properly authorized and received equipment.
• Cheques for large-euro purchases are not signed by two officers of Kida Company to
ensure that material expenditures are proper.
• All documentation to support a cheque is not canceled by the cheque signer and
returned to the accounts payable department.
• The cashier alone has custody of the key, the signature plate, and record of usage.
• The controller is authorized to sign cheques.
11-15 The substantive audit procedures Coltrane should apply to Jang’s trade accounts
payable balances include the following:
• Foot the schedule of the trade accounts payable.
• Agree the total of the schedule to the general ledger trial balance.
• Compare a sample of individual account balances from the schedule with the accounts
payable subsidiary ledger.
• Compare a sample of individual account balances from the accounts payable subsidiary
ledger with the schedule.
• Investigate and discuss with management any old or disputed payables.
• Investigate debit balances and, if significant, consider requesting positive confirmations
and propose reclassification of the amounts.
• Review the minutes of the board of directors’ meetings and any written agreements and
inquire of key employees as to whether any assets are pledged to collateralize payables.
• Perform cutoff tests.
• Perform analytical procedures.
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Confirm or verify recorded accounts payable balances by:
• Reviewing the voucher register or subsidiary accounts payable ledger and consider
confirming payables for a sample of vendors.
• Requesting a sample of vendors to provide statements of account balances as of the
date selected.
• Investigating and reconciling differences discovered during the confirmation procedures.
• Testing a sample of unconfirmed balances by examining the related vouchers, invoices,
purchase orders, and receiving reports.
Perform a search for unrecorded liabilities by:
• Examining files of receiving reports unmatched with vendors’ invoices and searching for
items received before the balance sheet date but not yet billed or on the schedule.
• Inspecting files of unprocessed invoices, purchase orders, and vendors’ statements.
• Reviewing support for the cash disbursements journal, the voucher register, or canceled
cheques for disbursements after the balance sheet date to identify transactions that
should have been recorded at the balance sheet date but were not.
• Inquiring of key employees about additional sources of unprocessed invoices or other
trade payables.
11-16
a.
b.
c.
d.
e.
5
3
4
6
1
11-17 Taylor should perform the following additional substantive audit procedures:
• Foot the client-prepared schedule.
• Agree the general ledger accounts payable control account to the client-prepared
accounts payable schedule.
• Examine vendors’ statement in support of items on the client-prepared schedule.
• Examine other documents (such as approved vouchers) in support of items on the clientprepared schedule.
• Review the general ledger control account for noncash debits or unusual items and
investigating them.
• Confirm, with positive confirmation requests, account balances from vendors with
account balances and vendors with zero account balances.
• Examine unpaid invoices on hand to ascertain whether any were erroneously omitted
from the client-prepared schedule of accounts payable.
• Examine documents in support of invoices paid subsequent to year-end to ascertain
whether the payable was recorded in the appropriate year.
• Inspect receiving reports to test the accuracy of the year-end cutoff.
• Ascertain whether year-end outstanding cheques to vendors were returned with the
cutoff bank statement.
• Review correspondence files with respect to disputed items.
• Review open purchase orders for unusual or old items that may have been received but
not recorded.
• Examine unmatched receiving reports.
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•
•
Make certain that the client representation letter includes the proper assertions
concerning accounts payable.
Investigate and resolve confirmation exceptions and other matters requiring follow-up.
Solution to Discussion Case
11-18
a.
The accounts payable audit procedures should be directed toward searching for proper
inclusion of all accounts payable and ascertaining that recorded amounts are reasonably stated
because the primary audit purpose is to reveal any possible material understatements.
The principal objectives of the accounts payable examination are:
1.
To determine adequacy of internal control for processing and payment of invoices.
2.
To prove that amounts shown on the balance sheet are in agreement with supporting
accounting records.
3.
To determine that liabilities existing at the balance sheet date have been reconciled.
b.
ISA 505 External Confirmations cover external conformations, including accounts
payable confirmations. There is no requirement to use accounts payable confirmation
procedures. ISA 505 states that the auditor generally should determine whether the use of
external confirmation is necessary to obtain sufficient appropriate evidence at the assertion.
Although not required, the accounts payable confirmation is often used. The auditor might
consider such use when:
1.
Internal controls are weak.
2.
The company is in a ‘tight’ cash position and bill paying is slow.
3.
Physical inventories exceed general ledger inventory balances by significant
amounts.
4.
Certain vendors do not send statements.
5. Vendor accounts are pledged by assets.
1.
Vendor accounts include unusual transactions.
2.
Change in personnel or management behavior related to payables.
c.
A selection technique using the large euro balances of accounts is generally used when
the primary audit objective is to test for overstatements (e.g. accounts receivable audit work).
Accounts with zero balances or relatively small balances would not be subjected to selection
under such an approach. When auditing accounts payable, the auditor is primarily concerned
with the possibility of unrecorded payables or understatement of recorded payables. Selection
of accounts with relatively small or no balances for confirmation is the more efficient direction of
testing, since understatements are more likely to be detected when examining such accounts.
When selecting accounts payable for confirmation, the following procedures could be
followed:
1.
Analyze the accounts payable population and stratify it into accounts with large
balances, accounts with small balances, accounts with zero balances, etc.
2.
Use a sampling technique that selects items based on criteria other than the
monetary amount of the items (e.g. select based on terminal digits, select every nth
item based on predetermined interval, etc.).
3.
Design a statistical sampling plan that will place more emphasis on selecting
accounts with zero balances or relatively small balances, particularly when the client
has had substantial transactions with such vendors during the year.
4.
Select prior-year vendors who are no longer used.
5.
Select new vendors used in the subsequent period.
6.
Select vendors that do not provide periodic statements.
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7.
8.
Select accounts reflecting unusual transactions during the year.
Select accounts secured by pledged assets.
Solution to Internet Assignments
11-19 It may be difficult to get information directly on some of EarthWear’s competitors. Your
search could be for financial statements of catalogue sportswear retailers in your home country
or in other countries. For example, Lands’ End is owned by Sears while Eddie Bauer is part of
The Spiegel Group. Timberland is a publicly traded company.
11-20 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for revenue recognition issues.
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CHAPTER 12
AUDITING THE HUMAN RESOURCE
MANAGEMENT PROCESS
Answers to Review Questions
12-1 Most entities either computerize their payroll systems or use an outside service bureau
because of the routine nature of payroll transactions.
12-2 There are two major types of transactions that are processed through the human
resource management process: (1) payments to employees for services rendered and (2)
accrual and payment of payroll-related liabilities arising from employees’ services.
The financial statements accounts that are generally affected by the two types of payroll-related
transactions are:
Payroll transaction:
• Cash
• Inventory
• Direct and indirect labour expense
• Various payroll-related liability and expense accounts
Accrued payroll liability transactions:
• Cash
• Various accruals (e.g. payroll taxes, and pension costs)
12-3 The payroll register, which is also referred to as the payroll journal, is a summary of all
payroll payments issued to employees. The payroll master file is the computer file that
maintains all the entity’s records related to payroll, including information on each employee such
as name, identification number, pay rate and authorized deductions. The payroll master file
changes report contains a record of the changes made to the payroll master file.
12-4
The following duties are performed in the personnel, timekeeping and payroll-processing
functions:
Personnel: Authorization of hiring, firing, wage rates and salary adjustments, salaries and
payroll deductions.
Timekeeping: Processing of employees’ attendance and time information and coding of
account distribution.
Payroll processing: Computation of gross pay, deductions, and net pay; recording and
summarizing of payments; and verification of account distribution.
12-5
The following table contains the key segregation of duties in the human resource management
process and possible errors and fraud that can occur if such segregation of duties is not
present.
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Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The supervision function should be
segregated from the personnel records
and payroll-processing functions.
Unauthorized payments to existing
employees or payments to fictitious
employees.
The disbursement function should be
segregated from the personnel records,
supervision
and
payroll-processing
functions.
Unauthorized payroll
may be made.
The payroll-processing function should be
segregated from the general ledger
function.
Concealment of a defalcation that
would normally be detected by
independent review of accounting
entries made to the general ledger.
disbursements
12-6
Two control environment factors that have a pervasive effect on the human resource
management process must be considered. First, the entity’s organizational structure, its
personnel practices, and its methods used to assign authority and responsibility must be
examined. Second, the entity should have sound policies for hiring, training, promoting and
compensating employees. These policies should include specific authority and responsibility for
hiring and firing of employees, for setting wage rates and making salary changes, and for
establishing benefits.
12-7
The key authorization points within the human resource management process include
authorization procedures for hiring and terminating employees, setting pay rates, making
withholdings, awarding benefits and making payroll payments.
12-8
Client control procedures must exist for the classification assertion to ensure that the
appropriate payroll accounts are charged. If payroll is not properly classified between direct and
indirect labour, inventory and cost of goods sold may not be properly valued.
12-9
Except for executive compensation, there are generally very few inherent risk factors that affect
the human resource management process and its related accounts. Some factors the auditor
might consider include the effect of economic conditions on payroll costs, the supply of skilled
workers, the frequency of employee turnover, the presence of labour contracts and labour
legislation.
Because of the officers may have motive and opportunity to take advantage of their highranking offices in the form of excessive compensation, inherent risk is frequently not set at low.
Key risk factors to consider are the level of performance-based compensation and the
closeness of key performance measures to compensation/bonus thresholds.
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12-10
Two audit procedures that can be performed using CAATs are: (1) testing the computer logic
used to calculate payroll amounts and (2) recomputing the calculation of gross pay, deductions
and net pay.
12-11 Substantive analytical procedures that can be used to test payroll accounts and payrollrelated accrual accounts are:
Payroll expense accounts:
1. Use a reasonableness test to develop an expectation based on number of
employees and prior year average compensation per employee category after
considering pay rate changes. Compare the expectation to current-year balance and
investigate the difference if it is greater than the threshold.
2. Compare payroll costs as a percentage of sales with prior years’ and industry data.
3. Compare labour utilization rates and statistics with industry data.
4.
Compare budgeted payroll expenses with actual payroll expenses.
5.
Estimate sales commissions by application of commission formulas to recorded sales
totals.
Payroll-related accrual accounts:
1.
Compare current-period balances in payroll-related accruals with the prior periods’
balances after adjusting for changes in conditions.
2.
Test reasonableness on accrual balances.
12-12
For the accrued payroll tax account, the auditor obtains a detailed account analysis schedule.
The credits to the account represent the recognition of payroll tax expense at the end of each
pay period. These amounts can be traced to the various payroll tax returns or other
documentation filed by the entity and should agree to the amount of payroll tax expense
included in the income statement. The debits to the account represent payments made to the
relevant government agencies. These payments can be verified by tracing the amounts to the
cash disbursements journal.
12-13
Disclosure items for the human resource management process and related accounts include:
• Pension disclosures.
• Postretirement benefits disclosures.
• Profit-sharing plans.
• Deferred-compensation arrangements.
Solutions to Problems
12-14
a.
•
Weaknesses in the internal control system are the following:
Lack of approval of the foreman’s clock card by an appropriate supervisor is an unsound
practice. Employees should not be permitted to maintain their own time records and
submit them without approval.
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•
•
•
•
•
•
•
•
•
b.
•
•
•
•
•
The computation of regular and overtime hours prepared by payroll clerk no. 2 that is
used in the preparation of the payroll register is not compared with the summary of
regular and overtime hours prepared by the foreman.
Arithmetic computations and rates of pay used in the preparation of the payroll register
are not checked by a person who is independent of their preparation, and payroll register
columns are not verified (re-added) by a person other than the preparer of the payroll
register.
Payroll cheques are not reconciled to the payroll register in order to prevent improper
disbursements.
A signature-stamp machine should not be in the custody of any payroll clerk who has
access to unsigned cheques.
An officer of the company does not approve payroll.
Since the paymaster should be independent of the payroll process, signed payroll
cheques should not be distributed by the foreman.
Unclaimed payroll cheques should be in the custody of an employee who is independent
of the payroll process.
The comparison of regular and overtime hours indicated on payroll cheques with regular
and overtime hours indicated on clock cards should not be performed by the clerk who is
responsible for the original computation of regular and overtime hours indicated on clock
cards.
The clerk who is responsible for preparing the payroll register should not perform the
comparison of gross and net payroll indicated on payroll cheque with gross and net
payroll indicated in the payroll register.
One should inquire whether:
Payroll clerk no. 2 checks clock cards for the foreman’s written approval.
Approved overtime is indicated on clock cards.
Employment, wage and related data in payroll files are periodically crosschecked with
personnel files for agreement.
A timekeeper observes the punching of clock cards.
Other mitigating internal control measures (e.g. bonding, required vacations and so
forth) are in existence.
12-15
McCarthy should consider performing the following procedures in the audit of Kent Company’s
payroll transactions:
1.
•
•
•
•
•
•
Select a sample of payments to employees from the payroll register and compare
each selected transaction to the related documents and records, and examine:
Evidence in support of authorization of pay rate.
Evidence in support of time on which compensation was based, such as approved
time cards or attendance records.
Evidence in support of proper authorization of payroll withholdings.
Evidence in support of account distribution.
The clerical accuracy of the transaction.
The entry to the employee’s records used to summarize employee compensation for
payroll reporting purposes.
.
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2.
Obtain the payroll register for a selected period and
• Test the arithmetic accuracy of the payroll register.
• Determine whether payroll was approved in accordance with management’s
prescribed procedures.
• Trace totals per the register to postings in the general ledger.
Observe the distribution of payroll cheques.
Review the accounting for unclaimed wages.
Observe a sample of employees in the performance of their duties.
Perform analytical procedures.
3.
4.
5.
6.
12-16
a.
In order to verify the information in the input form, James should:
• Compare the names, identification numbers, and withholding data on the input form with
the forms to authorize the withholding of income taxes.
• Compare names with employment authorizations.
• Compare pay rates with wage authorizations and union contracts.
• Compare numbers of hours worked (regular and overtime) with approved time sheets or
other supportive records; recompute regular and overtime hours.
• Inspect employee authorization forms for ‘special deductions.’
b.
James should perform the following procedures in the examination of the 24 November,
2005, payroll register:
• Compare information on the input form with information in the payroll register and
information on issued payroll cheques (e.g. spelling of names, correctness of
identification numbers, hours, rates and deductions).
• Test payroll deductions by using withholding tax tables to recompute social security and
withholding taxes.
• Manually compute gross and net pay and compare with computer printed figures.
• Compare payroll summary totals with other pay periods and investigate any unusual
variations among periods.
• Check footings and crossfootings in the payroll register.
• Perform other related basic auditing procedures that may be deemed necessary in
accordance with the circumstances.
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Solutions to Discussion Cases
12-17
The following edit checks might be used to detect errors during the typing of answers to the
input cues:
• Password: Ensures that the operator is authorized to access computer programs and
files.
• Numeric check: Ensures that numbers are entered into and accepted by the system
where only numbers are required to be entered, e.g. numbers 0-9 in employee
identification number.
• Alphabetic check: Ensures that letters are entered into and accepted by the system
where only letters are required to be entered, e.g. letters A-Z in employee name.
• Special-character check: Ensures that only specific special characters are entered into
and accepted by the system where only those special characters are required to be
entered, e.g. hyphens between numbers in identification number.
• Sign check: Ensures that positive or negative signs are entered into and accepted by the
system where only such signs are required to be entered or that the absence of a
positive or negative sign appears where such an absence is required, e.g. hours worked.
• Arithmetic check: Ensures the validity of the result of a mathematical computation, e.g.
total employees for period equal number of employee numbers in system.
• Validity check: Ensures that only authorized data codes will be entered into and
accepted by the system where only such authorized data codes are required, e.g.
authorized employee account numbers.
• Limit (reasonableness) check: Ensures that only data within predetermined limits will be
entered into and accepted by the system, e.g. rate per hour cannot be lower than the
minimum set by law or higher than the maximum set by management.
• Self-checking digit: Ensures that only specific code numbers prepared by using a
specific arithmetic operation will be entered into and accepted by the system, e.g.
employee numbers generated by the modulus 11 method with prime-number weighting.
• Size check: Ensures that only data using fixed or defined field lengths will be entered
into and accepted by the system, e.g. number of dependents requires exactly two digits.
• Missing-data check: Ensures that no blanks will be entered into and accepted into the
system when data should be present, e.g. an ‘S’ or ‘M’ is entered in response to ‘single
or married?’
• Overflow check: Ensures that no digits are dropped if a number becomes too large for a
variable during processing, e.g. hourly rates ‘on size errors’ are detected
• Control-total check: Ensures that no unauthorized changes are made to specified data or
data fields and all data have been entered.
• Logic check: Ensures that spurious data are rejected, e.g. no negative regular hours.
12-18
Data on employees’ compensation expense, total number of employees and salaries of the
executive officers are usually found in the company’s annual report. A rough estimate of the
average employee’s salary can be computed by dividing the estimated employee
compensation expense by the estimated total number of employees. The salary for one
officer divided by the average salary equals the proportion of executive salary to average
employee salary.
You may find that proportion of executive compensation to average salary is high, e.g.
ratios of ten to one or higher. It is argued that this proportion should be high because of the
value of the executive’s strategic influence on the company. Whether or not this is true depends
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entirely on the circumstances of the company. Recently there has been increased public
outrage at the large disparity between top executive salary and that of the average employee.
a.
It is argued that if executive compensation is tied to the value of the stock price
then executives will perform better, because their interests will be aligned with those
of the company’s stockholders.
Also by using stock based compensation,
companies are free to use the cash that would have been used as compensation to
fund other areas of the company. This strategy is frequently employed by
technology companies seeking rapid growth. Also the applicable financial reporting
framework may not require options to be expensed directly to the income statement.
The biggest disadvantage is the potential greed associated with high levels of
stock-option compensation. When the executive stands to gain tens or hundreds of
millions by achieving earnings targets, the executive’s self interests provides
incentives for earnings management or fraud in order to meet or beat earnings
forecasts.
b.
Potential audit procedures may include:
• Analytical procedures can be used to benchmark compensation levels to
other companies in the industry and to examine trends over time.
• Evaluate whether there is proper objectivity in establishing compensation
(i.e. is there a compensation committee independent of management).
Examine minutes of board of directors and compensation committee for
approval of executive compensation and information on other cash transfers
(e.g. loans, expense reimbursement).
• Use CAAT to search for payments to executives, or parties related to
executives.
• If fraud or embezzlement is suspected, hire a private investigator to evaluate
if executive is seemingly living beyond their compensation level.
Solution to Internet Assignment
12-19 A search of the Internet showed a number of sites that contained information on the
retail industry. For some of these sites, however, the user must be a member to obtain
information. A number of the major audit firms’ home pages contained information on the retail
industry. Lastly, some financial services companies, such as Standard & Poors have sites that
contain links to the retail industry.
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CHAPTER 13
AUDITING THE INVENTORY MANAGEMENT PROCESS
Answers to Review Questions
13-1
Inventory represents one of the most complex parts of the audit because the
assignment of values to inventory quantities is difficult. There are also issues such as
obsolescence and lower of cost or value (net realizable value) that affect the valuation of
inventory. The complexity of auditing inventory may also be affected by the degree of
processing required to manufacture products.
13-2
The inventory process is affected by control activities in the revenue, purchasing and
human resource management processes. The purchasing process controls the acquisition and
payment of raw materials and overhead costs. The cost of direct and indirect labour assigned
to inventory is controlled through the human resource management process. Last, finished
goods are sold and accounted for as part of the revenue process.
13-3
A production schedule is used to determine the quantity of goods needed and the time
at which they are required to meet the production scheduling. The materials requisition is the
document that authorizes the release of raw materials from the raw materials department. The
inventory master file contains all the important information related to the entity’s inventory,
including the perpetual inventory records for raw material, work in process and finished goods.
Production data information is reported about the transfer of goods and related cost
accumulation at each stage of production. This information is used to update the entity’s
perpetual inventory system and as input to generate the cost accumulation and variance reports
that are produced by the inventory system. The cost accumulation report summarizes the
various costs charged to departments and products and presents the results of inventory
processing in terms of actual costs versus standard or budgeted costs.
13-4
The following duties are performed by the production management, stores and cost
accounting functions:
Inventory management:
Raw materials stores:
Cost accounting:
Authorization of production activity and maintenance of inventory
at appropriate levels; issuance of purchase requisitions to the
purchasing department
Custody of raw materials and issuance of raw materials to
manufacturing departments
Maintenance of the cost of manufacturing and inventory in cost
accounting records
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13-5
The key segregation of duties in the inventory process and the errors or fraud that they
can prevent are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The inventory management function
should be segregated from the costaccounting function.
Production and inventory costs can be
manipulated, leading to an over- or
understatement of inventory and net income.
The inventory stores function should
be segregated from the costaccounting function.
Unauthorized shipments can be made or the
theft of goods can be covered up.
The cost-accounting function should be
segregated from the general ledger
function.
Unauthorized shipments resulting in theft of
goods, leading to an overstatement of
inventory.
The responsibility for supervising the
taking of physical inventory should be
separated
from
the
inventory
management and inventory stores
functions.
Inventory shortages can be covered up
through the adjustment of the inventory
records to the physical inventory resulting in
an overstatement of inventory.
13-6
Industry-related factors, and operating and engagement inherent risk factors affect the
inventory process. Industry factors include industry competition and changes in technology.
Operating and engagement characteristics are (1) the susceptibility of the products sold by the
client to theft, (2) the difficulty in auditing and valuing inventory, and (3) possible related-party
transactions for the acquisition of raw materials and sale of the finished product.
13-7
The three major steps in assessing control risk in the inventory process are:
1. Understanding and documenting the inventory internal control system based on the
planned level of control risk.
2. Planning and performing tests of controls on inventory process transactions.
3. Assessing and documenting control risk for the inventory process.
13-8
The following control activities can be used by the client to prevent unauthorized
inventory production:
• Preparation and review of an authorized production schedule.
• Use of material requirements planning and/or just-in-time inventory systems.
• Review of inventory levels by the inventory management department.
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13-9
Substantive analytical procedures that can be used to test inventory and related
account balances include:
• Compare raw material, finished goods, and total inventory turnover to previous
periods’ and industry averages.
• Compare days outstanding in inventory to previous periods and industry data.
• Compare gross profit percentage by product line with previous periods’ and industry
data.
• Compare actual cost of goods sold to budgeted amounts.
• Compare current-year standard costs with prior periods’ after considering current
conditions.
• Compare actual manufacturing overhead costs with budgeted or standard
manufacturing overhead costs.
13-10 To audit standard costs, the auditor should first review the client’s policies and
procedures for constructing standard costs. Once the policies and procedures are understood,
the auditor normally tests the component cost build-up for materials, labour, and overhead for a
representative sample of standard product costs. The material component requires testing of
the quantity and type of materials included in the product and the price of the materials. The
quantity and type of materials are tested by reviewing the engineering specifications for the
product. Labour costs require evidence about the type and amount of labour needed for
production and the labour rate. The amount of labour necessary to assemble a product can be
tested by reviewing engineering estimates, which may be based on time-and-motion studies or
historical information. The labour rates for each type of labour necessary to assemble a product
can be tested by examining a schedule of authorized wages. Overhead costs are tested by
reviewing the client’s method of overhead allocation for reasonableness, compliance with the
applicable financial reporting framework, and consistency. The auditor examines the costs
included in overhead to ensure that such costs are appropriate costs assignable to the product
and that the inclusion or exclusion of such costs is consistent from one period to the next.
13-11 During the observation of the physical inventory count, the auditor should perform the
following procedures:
• Ensure that no production is scheduled. Or, if production is scheduled, ensure that
proper controls are established for movement between departments in order to
prevent double counting.
• Ensure that there is no movement of goods during the inventory count. If movement
is necessary, the auditor and client personnel must ensure that the goods are not
double counted and that all goods are counted.
• Make sure that the client’s count teams are following the inventory count instructions.
• Ensure that inventory tags are issued sequentially to individual departments. If the
client uses another method of counting inventory, such as detailed inventory listings,
the auditor should obtain copies of the listings prior to the start of the inventory
count.
• Perform test counts and record a sample of counts in the workpapers.
• Obtain tag control information for testing the client’s inventory compilation. Tag
control information includes documentation of the numerical sequence of all
inventory tags and accounting for all used and unused inventory tags.
• Obtain cutoff information, including the number of the last shipping and receiving
documents issued on the date of the physical inventory count.
• Observe the condition of the inventory for items that may be obsolete, slow moving,
or carried in excess quantities.
• Inquire about goods held on consignment for others or held on a ‘bill and hold’ basis.
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The auditor must also inquire about goods held on consignment for the client.
13-12
Possible causes of book-to-physical differences include:
• Inventory cutoff errors.
• Unreported scrap or spoilage.
• Pilferage or theft.
13-13
Example disclosure items for inventory and related accounts include:
• Cost method (FIFO or weighted average).
• Components of inventory.
• Long-term purchase contracts.
• Consigned inventory.
• Purchases from related parties.
• Pledged or assigned inventory.
• Expenses from write-downs of inventory or losses on long-term purchase
commitments.
• Warranty obligations.
Solutions to Problems
13-14 The identification and explanation of the systems and control weaknesses are as
follows:
• The purchase requisition is not approved. A responsible person in the stores
department should approve the purchase requisition. The approval should be
indicated on the purchase requisition after the approver is satisfied that it was
properly prepared based on a need to replace stores or the proper request from a
user department.
• Purchase requisition number 2 is not required.
Purchase requisitions are
unnecessarily sent from the stores department to the receiving room. The receiving
room does not make any use of the purchase requisitions, and no purpose seems to
exist for the receiving room to obtain a copy. A copy of the requisition might be sent
from the stores department directly to the accounts payable department, where it
can be compared to the purchase order to verify that merchandise requisitioned by
an authorized employee has been properly ordered.
• Purchase requisitions and purchase orders are not compared in the stores
department. Although purchase orders are attached to purchase requisitions in the
stores department, there is no indication that any comparison is made of the two
documents. Prior to attaching the purchase order to the purchase requisition, the
requisitioner’s functions should include a check that (1) prices are reasonable, (2)
the quality of the materials ordered is acceptable, (3) delivery dates are in
accordance with company needs, and (4) all pertinent data on the purchase order
and purchase requisition (e.g. quantities, specifications, delivery dates, etc.) are in
agreement. Since the requisitioner will be charged for the materials ordered, the
requisitioner is the logical person to perform these steps.
• Purchase orders and purchase requisitions should not be combined and filed with
the unmatched purchase requisitions in the stores department. A separate file
should be maintained for the combined and matched documents. The unmatched
purchase requisitions file can serve as a control over merchandise requisitioned but
not yet ordered.
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•
•
•
•
•
•
•
•
•
•
•
Preliminary review should be made before preparing purchase orders. Prior to
preparation of the purchase order, the purchase office should review the company’s
need for the specific materials requisitioned and approve the request.
The purchase office should attempt to obtain the highest-quality merchandise at the
lowest possible price, and the procedures that are followed to achieve this should be
included on the flowchart. There is no indication that the purchase office submits
purchase orders to competitive bidding when appropriate. That office should be
directly involved with vendors in determining the cost of materials ordered and
should be primarily responsible for deciding at what price materials should be
ordered and which vendors should be used.
The purchase office does not review the invoice prior to processing approval. The
purchase office should review the vendor’s invoice for overall accuracy and
completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the
invoice is in agreement with the purchase order, receiving report, and purchase
requisition, the purchase office should clearly indicate on the invoice that it is
approved for payment processing. The approved invoice should be sent to the
accounts payable department.
The copy of the purchase order sent to the receiving room generally should not
show quantities ordered, thus forcing the department to count goods received. In
addition to counting the merchandise received from the vendor, receiving
department personnel should examine the condition and quality of the merchandise
upon receipt.
There is no indication of the procedures in effect when the quantity of merchandise
received differs from what was ordered. Procedures for handling overshipments
should be clearly outlined and included on the flowchart.
The receiving report is not sent to the stores department. A copy of the receiving
report should be sent from the receiving room directly to the stores department with
the materials received. The stores department, after verifying the accuracy of the
receiving report, should indicate approval on that copy and send it to the accounts
payable department. The copy sent to the accounts payable department will serve
as proof that the company received the materials ordered and are in the user
department.
There is no indication of control over vouchers in the accounts payable department.
In the accounts payable department a record of all vouchers submitted to the
cashier should be maintained, and a copy of the vouchers should be filed in an
alphabetical vendor reference file.
There is no indication of control over monetary amounts on vouchers. Accounts
payable personnel should prepare and maintain control sheets on the monetary
amounts of vouchers. Such sheets should be sent to departments posting
transactions to general and subsidiary ledgers.
There is no examination of documents prior to voucher preparation. In addition to
the matching procedure, the mathematical accuracy of all documents should be
verified prior to preparation of vouchers.
The controller should not be responsible for cash disbursements. The cash
disbursement function should be the responsibility of the treasurer, not the
controller, so as to provide proper division of responsibility between the custody of
assets and the recording of transactions.
There is no indication of the company’s procedures for handling purchase returns.
Although separate return procedures may be in effect and included on a separate
flowchart, some indications of this should be included as part of the purchases
flowchart.
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• Discrepancy procedures are not indicated. The flowchart should indicate what
procedures are followed whenever matching reveals a difference between the
information on the documents compared.
• There is no indication of any control over prenumbered forms. All prenumbered
documents should be accounted for.
13-15 a. Evidence found in the working papers to support the fact that the audit was
adequately planned and assistants were properly supervised would be:
• Documentation indicating discussions with client personnel concerning
developments affecting the entity that require recognition in the audit plan.
• Documentation of a preaudit planning conference among audit firm personnel to
develop an audit strategy by considering matters noted in the review of prior
years’ working papers, changes in accounting and auditing standards, etc.
• An internal control write-up documenting that the internal control system had
been reviewed.
• Audit plans tailored to the strengths and weaknesses of the internal control
system (i.e. tested the relevant assertions).
• Audit plans indicating steps that were assigned to and completed by individual
assistants.
• A budget indicating the time to be spent in each audit area.
• Individual working papers signed by reviewers to document review, approval and
responsibility.
• Confirmations that all questions raised by assistants were answered.
b. Substantive tests that would document management’s completeness assertion as it
relates to inventory quantities would be:
• Observation of physical inventory counts.
• Analytical procedures for the relationship of inventory balances to purchase,
production, and sales activities.
• Inspection of shipping and receiving documentation for proper amounts and
dates to verify proper cutoff procedures.
• Obtaining of confirmation of inventories at locations outside the entity.
• Tracing of test counts recorded during the physical inventory observation to the
inventory listing.
• Accounting for all inventory tags and count sheets used in recording the physical
inventory counts.
• Recomputation of the inventory calculations for clerical accuracy.
• Reconciliation of physical counts to perpetual records and general ledger
balances and investigation of significant differences.
13-16 a. When a client uses statistical sampling to estimate inventories, the auditor should
perform procedures similar to the following:
• The auditor should review the client’s procedures and methods for determining
inventories to ascertain that they are sufficiently reliable to produce results
substantially the same as those that would be obtained by a 100 per cent
inventory count.
• The auditor should be satisfied that the statistical sampling plan to be used by
the client has statistical validity, that it will be properly applied, and that the
planned tolerable and expected misstatement and risk of incorrect acceptance
will be reasonable in the circumstances.
• The auditor should ascertain that proper steps have been taken to ensure that all
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•
•
•
parts and supplies in the warehouse are included in the perpetual inventory
records. This would normally be checked in advance of the physical count.
The auditor should be present when the sample is drawn to make sure that the
requirements for random selection are properly observed and that all items in the
inventory have an equal or determinable probability of selection.
The auditor must be present to observe counts and must be satisfied with the
client’s counting procedures. The inventory observation can be made either
during or after the year-end of the period under audit if well-kept perpetual
records are maintained and the client makes periodic comparisons of physical
counts with such records.
The auditor should review the statistical evaluation and be satisfied that the
estimated value of the precision at a given level of reliability meets the materiality
requirements set for the audit.
b. In addition to the above, the following standard audit procedures for verification of
physical quantities should be performed whether the client conducts a periodic
physical count for all or part of its inventory:
• Review and be satisfied with the client’s physical inventory-taking procedures.
• Observe the physical count.
• Make test counts where appropriate.
• Trace selected count data to the inventory compilation.
• Select items from compilation and trace them to original count data.
• Select items from the warehouse at random and trace these items to the
perpetual inventory records.
• Verify footings.
• Compare inventory compilation amounts to the subsidiary ledger control and
investigate significant differences.
• Ascertain that there was a proper purchases and sales cutoff.
• Review the treatment of merchandise in transit and consigned merchandise.
• Confirm merchandise in warehouses.
• Perform analytical procedures for inventories.
• Account for all client inventory count sheets.
• Be sure inventory items are properly classified, in good condition, and of proper
quality.
13-17 The substantive auditing procedures Kachelmeier may consider performing include the
following:
Using the perpetual inventory file:
•
•
•
Recalculate the beginning and ending balances (prices x quantities), foot, and
print out a report to be used to reconcile the totals with the general ledger or
agree beginning balance with the prior year’s working papers.
Calculate the quantity balances as of the physical inventory date for comparison
to the physical inventory file. Alternatively, update the physical inventory file for
purchases and sales from 6 January to 31 January, 2005, for comparison to the
perpetual inventory at 31 January, 2005.
Select and print out a sample of items received and shipped for the periods (1)
before and after 5 January and 31 January, 2005, for cutoff testing, (2) between
5 January and 31 January, 2005, for vouching or analytical procedures, and (3)
prior to 5 January, 2005, for tests of details or analytical procedures.
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•
•
•
•
•
•
•
Compare quantities sold during the year to quantities on hand at year-end. Print
out a report of items for which turnover is less than expected. Alternatively,
calculate the number of days’ sales in inventory for selected items.
Select items noted as possibly unsalable or obsolete during the physical
inventory observation and print out information about purchases and sales for
further consideration.
Recalculate the prices used to value the year-end FIFO inventory by matching
prices and quantities to the most recent purchases.
Select a sample of items for comparison to current sales prices.
Identify and print out unusual transactions. These are transactions other than
purchases or sales for the year, or physical inventory adjustments as of 5
January, 2005.
Recalculate the ending inventory by taking the beginning balances plus
purchases, less sales, and print out the differences.
Recalculate the cost of sales for selected items sold during the year.
Using the physical inventory and test count files:
•
•
•
•
•
•
•
Account for all inventory tag numbers used and print out a report of missing or
duplicate numbers for follow-up.
Search for tag numbers noted during the physical inventory observation as being
voided or not used.
Compare the physical inventory file to the file of test counts and print out a report
of differences for auditor follow-up.
Combine the quantities for each item appearing on more than one inventory tag
number for comparison to the perpetual file.
Compare the quantities on the file to the calculated quantity balances on the
perpetual inventory file as of 5 January, 2005. Alternatively, compare the
physical inventory file updated to year end to the perpetual inventory file.
Calculate the quantities and monetary amounts of the book-to-physical
adjustments for each item and the total adjustment. Print out a report to
reconcile the total adjustment to the adjustment recorded in the general ledger
before year-end.
Using the calculated book-to-physical adjustments for each item, compare the
quantities and monetary amounts of each adjustment to the perpetual inventory
file as of 5 January, 2005, and print out a report of differences for follow-up.
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13-18
Basic
Inventory
Procedures
Auditing
How a General-Purpose Computer
Software Package and Tape of
Inventory File Data Might Be Helpful
1. Observation of the physical count,
making and recording test counts
where applicable.
1. By determining which items are to be
test counted by selecting a random
sample of a representative number of
items from the inventory file as of the
date of the physical count.
2. Testing of the mathematical
accuracy
of
the
inventory
compilation.
2. By mathematically computing the
monetary value of each inventory item
counted by multiplying the quantity on
hand by the cost per unit and verifying
the addition of the extended monetary
values.
3. Comparison of the auditor’s test
counts to the inventory records.
3. By arranging test counts in a tape
format identical to the inventory file
and matching the tapes.
4. Comparison of physical count data
to inventory records.
4. By comparing the total extended
values of all inventory items counted
and the extended values of each
inventory item counted to the
inventory records.
5. Testing of the inventory pricing by
obtaining a list of costs per item
from buyers, vendors, or other
sources.
5. By preparing a tape in a format
identical to the tape of the inventory
file and matching the tapes.
6. Examination of purchases and
sales cutoff.
6. By listing a sample of items on the
inventory file for which the date of last
purchase and date of last sale are on
or immediately prior to the date of the
physical count.
7. Ascertainment of the propriety of
items of inventory located in
public warehouses.
7. By listing items located in public
warehouses.
8. Analysis of inventory for evidence
of possible obsolescence.
8. By listing items on the inventory file for
which the quantity on hand is
excessive in relation to the quantity
sold during the year.
9. Analysis of inventory for evidence
of possible overstocking or slow-
9. By listing items on the inventory file for
which the quantity on hand is
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moving items.
excessive in relation to the quantity
sold during the year.
10. Performance of an overall test for
accuracy of inventory master file.
13-19 a.
b.
c.
d.
e.
10. By listing items, if any, with negative
quantities or costs.
6
3
1
4
2
Solution to Discussion Case
13-20 a. The auditors did not follow the following audit procedures in a satisfactory manner:
• Control of count sheets during and after the inventory. There may not have been
adequate supervision and instruction of the inventory observation teams by the
auditors. There is no evidence that there was adequate preplanning of the
inventory count. Even though it is difficult to spend continuous time in the upper
decks, there must be a careful control over their contents and planned counting
must still be observed.
• Although the late addition of such sheets is highly irregular, the auditors did very
little to satisfy themselves of their accuracy. The altering of count sheets after
the auditors left could have been prevented by ‘lining out’ unused portions of the
count sheet prior to leaving the inventory observation. Test counts of lines on
sheets could also have detected the changes
• Physically examining inventory represented on additional count sheets with
specific assurances that the items did not represent a duplication in the count.
Tracing the items to purchase invoices does not prove existence at the inventory
date, only that the items were at one time bona fide.
• Questions about inventory turnover and similar comparisons should have been
raised and addressed.
• If the additional items listed on the four additional sheets, the changing of unit
designations, or the fictitious amounts added to completed sheets created
unusual balances in specific inventory items, a review of the inventory balances
and comparison with previous years’ would have indicated unusual increases.
Because of the weaknesses in inventory control, audit procedures should have
been expanded.
b. Failure to obtain adequate evidence to support management’s assertions can result
in legal liability from injured third parties and in sanctions by the supervisory
authorities (e.g. suspension or revoke of license to practice, fines, or reprimands).
c. Auditing standards require (ISA 260) the auditor to communicate audit matters of
governance interest arising from the audit of financial statements with those charged
with governance of the entity (i.e. the board of directors, audit committee or
supervisory board). This includes matters such as material weaknesses in internal
control, questions regarding management integrity, and fraud involving management.
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Solution to Internet Assignment
13-21
A search of the Internet showed a number of sites that contained financial
information on the retail industry. Some of these sites require that the user must be a member
to obtain information. A number of the major audit firms’ home pages contained information on
the retail industry, as does Andersen Consulting. Finally, financial services companies; such as
Standard & Poors have sites that contain links to the retail industry. However, these services
may be available by subscription only.
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CHAPTER 14
AUDITING FINANCING PROCESS: PREPAID
EXPENSES AND PROPERTY, PLANT AND EQUIPMENT
Answers to Review Questions
14-1 Prepaid expenses provide economic benefit for less than a year. Deferred expenses
and intangible assets provide economic benefit for longer than a year, therefore misstatements
can occur which affect multiple periods. Examples of prepaid expenses include:
• Prepaid insurance
• Prepaid rent
• Prepaid interest
Examples of deferred expenses and intangible assets include:
• Organization costs
• Debt issuance costs
• Copyrights
• Trademarks
• Trade names
• Licenses
• Patents
• Franchises
• Goodwill
• Computer software development costs
14-2 Deferred expenses and intangible assets often present serious inherent risks because
there are possible judgment issues relating to the valuation and estimated lives of items such as
patents, franchises and goodwill. These issues can lead to disagreements between the auditor
and the client.
14-3 The purchasing process affects prepaid insurance and property, plant and equipment
transactions because such transactions are subject to the control activities included in the
purchasing process. For example, control activities in the purchasing process may provide
assurance as to the proper authorization and recording of insurance policies. Similarly, the
occurrence (validity) and authorization of property, plant and equipment transactions are
normally part of the purchasing process.
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14-4
Two substantive analytical procedures that can be used to test prepaid insurance are:
• Compare the current-period balance in prepaid insurance and insurance expense
with the prior periods’ balances after considering any changes in operations.
• Compute the ratio of insurance expense to assets or sales and compare it with the
prior periods’ ratios.
14-5 A confirmation from insurance brokers would include information on the policy number,
coverage, expiration date, deductibles and premiums.
14-6
Four types of property, plant and equipment transactions are:
• Acquisition of capital assets for cash or other non-monetary considerations.
• Disposition of capital assets through sale, exchange, retirement, or abandonment.
• Depreciation of capital assets over their useful economic life.
• Leasing of capital assets.
14-7 Three inherent risk factors that should be considered when assessing inherent risk for
property, plant and equipment are complex accounting issues, difficult-to-audit transactions, and
misstatements detected in prior audits. Lease accounting, self-constructed assets and
capitalized interest are examples of transactions that involve complex accounting issues. The
vast majority of property, plant and equipment transactions are relatively easy to audit.
However, transactions involving donated assets, non-monetary exchanges, and self-constructed
assets are more difficult to audit because it may be difficult to verify the value of such assets. If
the auditor has detected misstatements in prior audits, the likelihood of misstatements in the
current year is higher.
14-8 Most entities have some type of authorization table for approving capital asset
transactions. Control activities should be present to ensure that the authorization to purchase
capital assets is consistent with the authorization table. For example, the control activities
should specify monetary limits at each managerial level to ensure that larger projects are
brought to the attention of higher levels of management for approval before commitments are
made. The entity also needs to have control activities for authorizing the sale or other
disposition of capital assets. This should include a level of authorization above the department
initiating the disposition. Control activities should also identify assets that are no longer used in
operations, because they may require different accounting treatment. Finally, an appropriate
level of management should properly authorize all major maintenance or improvement
transactions.
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14-9 The key segregation of duties for property, plant and equipment and possible errors or
fraud that can occur if they are not present are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The initiation function should be
segregated from the final approval
function.
Fictitious or unauthorized purchases of
assets can occur, resulting in purchases of
unnecessary assets, assets that do not meet
the company’s quality control standards, or
illegal payments to suppliers or contractors.
The property, plant and equipment
records
function
should
be
segregated from the general ledger
function.
Conceal a defalcation that would normally
be detected by reconciling the subsidiary
records with the general ledger control
account.
The property, plant and equipment
records
function
should
be
segregated from the custodial
function.
Tools and equipment can be stolen and the
theft concealed by adjustment of the
accounting records.
If a periodic physical inventory of
property, plant and equipment is
taken, the individual responsible for
the inventory should be independent
of the custodial and record-keeping
functions.
Theft of the entity’s capital assets can be
concealed.
14-10 The following substantive analytical procedures can be used in the audit of property,
plant and equipment:
• Compare prior-year balances in property, plant and equipment and depreciation
expense with current-year balances after considering any changes in conditions or
asset composition.
• Compute the ratio of depreciation expense to the related property, plant and
equipment accounts and comparison to prior years’ ratios.
• Compute the ratio of repairs and maintenance expense to the related property, plant
and equipment accounts and compare to prior years’ ratios.
• Compute the ratio of insurance expense to the related property, plant and equipment
account and compare to prior years’ ratios.
• Review capital budgets and compare the amounts spent with the amounts budgeted.
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14-11 The following audit procedures can be used to verify the completeness, ownership, and
valuation assertions:
Completeness:
Rights and
Obligations:
Valuation:
Physically examine a sample of capital assets and trace them into the
property, plant and equipment subsidiary ledger.
Examine or confirm deeds or title documents for proof of ownership.
Vouch additions and dispositions to vendor invoices or other supporting
documentation.
Test depreciation calculations for a sample of capital assets.
Solutions to Problems
14-12 a. Two substantive analytical procedures that can be used to test prepaid insurance
are:
• Examine the trend in prepaid insurance over 3-5 years to develop an expectation
for the current year balance after considering any changes in operations.
Compare the expectation to the current-year balance and investigate the
difference if it is greater than the threshold.
• Compute the ratio of insurance expense to assets or sales and compare it with
the prior years’ ratios.
b. The following substantive tests should be performed on the schedule of prepaid
insurance:
• Foot the schedule and trace the ending balance to the prepaid insurance account
in the general ledger.
• Send confirmations to the entity’s insurance brokers, requesting information on
each policy’s number, coverage, expiration date and premiums; alternatively,
examine supporting documents such as insurance bills and policies.
• Compare the detailed policies in the current year’s insurance register with the
policies included in prior years’ insurance register.
• Recompute the unexpired portion of the prepaid insurance after considering the
premium paid and the term of the policy.
• Examine the insurance policy coverage and ensure that costs are properly
allocated to the various insurance expense accounts.
• Inquire of management or its insurance broker about the adequacy of the entity’s
insurance coverage.
14-13 a. Taylor should consider performing the following procedures in the audit of Palmer’s
goodwill account:
• Trace the totals in the account analysis for each significant acquisition to the
general ledger.
• Trace the opening balance to the audit working papers for the preceding year.
• Examine supporting documents for evidence of continued ownership of the
acquisitions that resulted in excess of costs over fair value of net assets.
• Review the reasonableness and consistency of application of the method of
amortization used.
• Determine that the amortization period is reasonable.
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•
•
•
•
•
•
Recompute amortization for book and tax purposes.
Determine that the carrying amount does not exceed amounts properly allocable
to future periods.
Assess whether there has been a permanent impairment of value.
Trace amounts amortized during the period to the related general ledger expense
accounts.
Examine evidence supporting additions and reductions during the year
Ascertain whether goodwill and amortization are properly described and
classified in the financial statements and disclosed in the notes to the financial
statements.
b. The two significant assertions that Taylor would be most concerned with relative to
Palmer’s goodwill are valuation or allocation, and presentation and disclosure.
Taylor would be most concerned with the risk of the loss of recoverability of the
goodwill’s market value due to the company’s not meeting profit expectations, as well
as the risk of inadequate disclosure or presentation in the financial statements.
14-14 The key internal controls related to Grant’s property, equipment, and related transactions
that Nakamura may consider in assessing control risk include the following:
• Advance approval in accordance with management’s criteria is required for property
and equipment transactions.
• Approval authority for transactions above an established monetary value is required
at a higher level, such as the board of directors.
• Property and equipment transactions are adequately documented.
• There are written policies covering capitalizing expenditures, classifying leases, and
determining estimated useful lives, salvage values, and methods of depreciation and
amortization.
• There are written policies covering retirement procedures that include serially
numbered retirement work orders, stating the reasons for retirement and bearing
appropriate approvals.
• There are adequate policies and procedures to determine whether property and
equipment are received and properly recorded, such as a system that matches
purchase orders, receiving reports and vendors’ invoices.
• There are adequate procedures to determine whether dispositions of property and
equipment are properly accounted for and proceeds, if any, are received in
accordance with management’s authorization.
• A property and equipment subsidiary ledger is maintained showing additions,
retirements, and depreciation, and the ledger is periodically reconciled.
• Property and equipment is physically inspected and reconciled at reasonable
intervals with independently maintained property and equipment records.
• An annual budget is prepared and monitored to forecast and control acquisitions and
retirements of property and equipment.
• Reporting procedures ensure prompt identification and analysis of variances
between authorized expenditures and actual costs.
• Adequate safeguards protect property and equipment.
• Property and equipment are insured in accordance with management’s authorization.
• Documents evidencing title and property rights are periodically compared with the
detailed property records.
• The entity employs internal auditors to test whether the internal controls are
operating effectively.
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14-15 a. Property, plant and equipment normally include only fixed tangible assets. Fixed
tangible assets are capital assets with useful lives generally in excess of one year
that are used in the operation of the business and that are not purchased for resale
purposes. In connection with the examination of property, plant and equipment
(PP&E), the auditor must be satisfied that:
• Internal controls over PP&E and PP&E acquisitions are adequate.
• Assets included in PP&E exist and are being used in the normal operations of the
business.
• Assets included in PP&E are owned by the company whose financial statements
are being examined.
• Assets included in PP&E are not encumbered by liens or, if so, the facts are
properly disclosed in the footnotes to the financial statements.
• Depreciation and/or amortization methods are proper.
• Amounts in the financial statements are in substantial agreement with the
supporting records.
• Accounting for additions, disposals and retirements is proper.
• Maintenance accounts do not include items that should be capitalized.
• The valuation and the disclosure of the method of evaluation are acceptable.
• Important information relating to the assets is properly disclosed.
b.
Item
Number
Is Audit Adjustment
or Reclassification
Required?
Reasons Why Audit Adjustment or
Reclassification Is Required or Not Required
1
Yes
Commissions paid to real estate agents are
costs directly related to the acquisition of the
property and should be included in the land cost.
The costs of removing, relocating or
reconstructing property of others to acquire
possessions are costs that are directly
attributable to conditioning the property for use
and should be included in land costs. An
adjustment is required for these items so that
total land costs can properly be included in
property, plant and equipment.
2
No
No adjustment is required because clearing
costs are costs that are directly attributable to
conditioning the property for use and should be
included in land costs, which are part of
property, plant and equipment.
3
Yes
Since clearing costs are costs of the land,
amounts realized from the sale of materials
recovered, such as timber and gravel, should be
a reduction of the cost of the land and should
not be recorded as other income.
4
Yes
All costs relating to the purchase of machinery
and equipment should be capitalized.
For
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purchased items such costs would include
invoice price, freight costs and unloading
charges. Royalty payments, however, should
not be included in the cost of the machinery.
Such payments should be charged to expenses
as they accrue. Machinery costs, other than
royalty payments, should be included in
property, plant and equipment.
14-16 a. 4
b. 7
c. 2
14-17 Substantive audit procedures that Pierce should use in examining Wong’s mobile
construction equipment and related depreciation would include the following:
• Determine that the equipment account is properly footed.
• Determine that the subsidiary accounts agree with controlling accounts.
• Obtain, or prepare, an analysis of changes in the account during the year.
• Determine that beginning-of-year balances agree with the prior year’s ending
balances.
• Inspect documents in support of additions during the year.
• Inspect documents in support of retirements during the year.
• Analyze repairs and maintenance for possible reclassifications.
• Determine the propriety of accounting for equipment not in current use.
• Test the accuracy of equipment and accounting records by (1) selecting items from
the accounting records and verifying their physical existence and (2) selecting items
of equipment and locating them in the accounting records.
• Evaluate the reasonableness of estimated lives and methods of depreciation used.
• Test the calculation of depreciation expense and accumulated depreciation balance.
• Perform analytical procedures such as comparing depreciation expense to balance
sheet accounts for proper relationship and compare the current year’s depreciation
expense with prior year’s depreciation expense.
• Evaluate the financial statement presentation and disclosures for conformity with
generally accepted accounting principles.
• Review insurance coverage.
Solution to Discussion Case
14-18
a. IAS 16 Property, Plant and Equipment states that an entity is required to derecognise
the carrying amount of an item of property, plant and equipment that it disposes of on
the date the criteria for the sale of goods in IAS 18 Revenue would be met. IAS 18
generally states that revenue is recognised when it is probable that future economic
benefits will flow to the entity and these benefits can be measured reliably, but lacks
specific guidance.
Because no closing has taken place, Leno’s transaction should not be accounted
for under full recognition. However, Leno may account for the transaction using
another method. US GAAP are close aligned to the general principles of IAS 18. US
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accounting pronouncements provide specific application guidance for revenue
recognition.
FASB No. 66 provides a number of alternative approaches for recognizing
revenue, including (1) the deposit method and (2) the cost recovery method. Under
the deposit method, no profit is recognized because the sale has not been
consummated. It can be argued that the deposit method is appropriate. The cost
recovery method can be used if the receipt of the irrevocable letter of credit is treated
as a separate transaction from the total sales transaction and profit is recognized on
this portion of the transaction independently of the remainder of the transaction. It
may be argued that the receipt of the irrevocable letter of credit can be treated as a
separate transaction from the total sales transaction and profit can be recognized on
this portion of the transaction independently of the remainder of the transaction.
Following the cost recovery method at 31 March, 2005, a gain of €1,580,000 would
be recognized on the difference between the amount of the irrevocable letter of credit
and the book value of the property. The property would be removed from Leno’s
balance sheet, and the letter of credit would be presented as a ‘deposit received
under contract of sale.’
b. Prior to recognizing any gain on the transaction, the auditor should:
• Examine the sales contract.
• Examine the letter of credit.
• Obtain a confirmation from the bank on the terms of the letter of credit.
• Examine the subsidiary records containing the information on the land and
building’s book value.
• Examine financial information on the buyer to determine its financial position.
Solution to Internet Assignment
14-19 It is difficult to get information directly on some of EarthWear’s competitors. Your search
could be for financial statements of catalogue sportswear retailers in your home country or in
other countries. For example, Eddie Bauer is part of The Spiegel Group. The Spiegel Group’s
annual report states that depreciation is calculated using the straight-line method consistent with
EarthWear, and it appears that the useful lives of its assets are comparable to EarthWear.
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CHAPTER 15
AUDITING FINANCING PROCESS: LONG-TERM LIABILITIES, STOCKHOLDERS’
EQUITY AND INCOME STATEMENT ACCOUNTS
Answers to Review Questions
15-1 A substantive audit strategy is normally followed when auditing the long-term debt and
capital accounts because, although the number of transactions is smaller, each transaction is
usually material. Thus, it is normally more cost-effective to conduct substantive tests of the
transactions that compose the account balance.
15-2 The assertions for long-term debt that are most important to the auditor are occurrence,
authorization, completeness, valuation and classification. The documents that normally contain
the authorization to issue long-term debt include a properly signed lending agreement and the
minutes of board of directors’ meetings.
15-3 The auditor can estimate interest expense by multiplying the twelve monthly balances for
long-term debt by the average interest rate. The reasonableness of interest expense can then
be assessed by comparing this estimate to the interest expense amount recorded in the general
ledger. If the two amounts are not materially different, the auditor can conclude that interest
expense is fairly stated. If the estimated amount of interest expense is materially higher than
the recorded amount, the auditor might conclude that the client has failed to record a portion of
interest expense. On the other hand, if the recorded amount of interest expense was materially
higher than the estimated amount, the client may have failed to record debt. It is important to
remember that the inputs (i.e. interest rates, monthly balances) must be audited in order to
obtain assurance from the substantive analytical procedure.
15-4 Confirmation of long-term debt provides evidence on the existence, completeness and
valuation assertions.
15-5 When the client does not use an outside agent and a sufficient number of personnel are
available, the following segregation of duties should be maintained:
• The individuals responsible for issuing, transferring and cancelling stock certificates
should not have any accounting responsibilities.
• The individual responsible for maintaining the detailed stockholders’ records should
be independent of the maintenance of the general ledger control accounts.
• The individual responsible for maintaining the detailed stockholders’ records should
not also process cash receipts or disbursements.
• Appropriate segregation of duties should be established among the payment and
recording of dividend payments.
15-6 The two most common disclosures for stockholders’ equity are (1) the number of shares
authorized, issued and outstanding for each class of stock and (2) restrictions on retained
earnings and dividends. These disclosures are necessary so that stockholders can determine
what share of the company they own and whether there are any restrictions on the declaration
of dividends.
Other disclosures for stockholders’ equity include:
• Call privileges, prices, and dates for preferred stock.
• Stock option or purchase plans.
• Any completed or pending transactions (e.g. stock dividends or splits) that may affect
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stockholders’ equity.
15-7 When the entity uses an outside dividend-disbursing agent, the auditor can confirm the
amount disbursed to the agent by the entity. This amount is agreed with the amount authorized
by the board of directors. The auditor can recompute the dividend amount by multiplying the
number of shares outstanding on the record date by the amount of the per share dividend
approved by the board of directors. This amount should agree to the amount disbursed to
shareholders and accrued at year-end.
The auditor begins the audit of retained earnings by obtaining a schedule of the activity
in the account for the period. The beginning balance is agreed to the prior year’s working
papers and financial statements. Net income or loss can be traced to the income statement.
The amounts for any cash or stock dividends can be verified as in the previous paragraph. If
there are any prior-period adjustments, the auditor must be certain that the transactions satisfy
the requirements of the relevant accounting standards. Any new appropriations or changes in
existing appropriations should be traced to the contractual agreement that required the
appropriation. Last, the auditor must make sure that all necessary disclosures related to
retained earnings are made in the notes.
15-8 Three substantive analytical procedures that the auditor might use in auditing the income
statement include:
• Use the prior years’ trends in quarterly euro (or other currency) amount for each
significant revenue and expense account (e.g. disaggregate revenue by product or
location) to develop an expectation for the current year.
• Calculate the ratio of individual expense accounts to net sales and comparing these
percentages across years.
• Perform direct substantive tests of specific revenue or expense accounts (e.g. sales
commissions can be tested by using the client’s commission schedule and multiplying
the commission rates times eligible sales).
15-9
The auditor conducts a detailed analysis of the transactions in legal expense, travel and
entertainment, and other income expense because these are accounts that are not directly
affected by an accounting process, accounts which contain sensitive information or unusual
transactions, or accounts for which detailed information is needed for the tax return or other
schedules included with the financial statements.
Solutions to Problems
15-10 a. The procedures that Maslovskaya should employ in examining the loans are as
follows:
• Obtain an understanding of the business purpose of the loans made by the
president.
• Confirm the loans, including terms, by direct communication.
• Recompute (or verifying) interest expense and interest payable.
• Recompute the long-term and short-term portions of the debt.
• Review minutes of meetings of the board of directors for proper authorization.
• Verify payments made during the year and transactions after year-end.
• Read the financial statements, including notes and loan agreements, and
evaluating the adequacy of disclosure and compliance with restrictions.
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• Consider any tax implications for the interest on the loan from the company’s
president.
• Obtain a management representation letter.
b. Broadwall’s financial statements should normally disclose the following information
concerning the loans from its president:
• The nature of the related-party relationship.
• The monetary amounts of the loans.
• Amounts due the president and, if not otherwise apparent, the terms and manner
of settlement.
15-11 a. Rekdahl should perform the following audit steps to determine if the company is in
compliance with the bond indentures:
• Calculate the working capital ratio to ensure that it is 2 to 1 at the end of each
month during the fiscal year.
• If the working capital ratio is less than 2 to 1, verify that the total compensation of
the chairperson and president is not more than €650,000.
• Confirm with the trustee that insurance policies protecting against fire loss to the
extent of 100 per cent of value have been filed.
• Test retained earnings to ensure that 40 per cent has been restricted from dividend
payments.
• Confirm with the First Euro Bank that a sinking fund has been established and that
the required semiannual payments have been made.
• Confirm whether any bonds have been repurchased.
b. The following disclosures should normally be made:
• The amount, interest rate, and due date of each bond issue.
• The covenant restrictions on the bond indentures.
• The amount of debt due over each of the next five years.
15-12 The
•
•
•
•
•
•
•
•
•
•
•
•
•
working paper contains the following deficiencies:
Index number of the working paper is missing.
The subject of the working paper is not properly indicated in the title.
There is no indication of any follow-up on the identified error in the accrued interest
payable computation.
There is no indication as to whether the confirmation exception was resolved.
The loan with the unwaived violation of a provision of the debt agreement is
misclassified as long-term.
The liability activities of Lender’s Capital Corp. and the working paper totals do not
crossfoot.
There is no indication of cross-referencing of the stockholder loan to the relatedparty transactions working papers.
There is no investigation of the payment on the stockholder loan that was
reborrowed soon after year-end.
There is no consideration of the need to impute interest expense on the 0 per cent
stockholder loan.
There is no indication that the dates under ‘Interest paid to’ were audited.
There is no indication that the unusually high average interest rate
(€281,333/€1,406,667 = 20%) was noted and investigated.
The working paper does not support the overall conclusions expressed.
The tick mark ‘R’ is used but not explained in the tick mark legend.
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• There is no indication that the working paper was prepared by client personnel.
Solutions to Discussion Case
15-13 a. There are a number of audit procedures that Johnson can conduct in order to
determine if the client is in violation of the debt agreement. Note that the possible
violation of the debt covenants may have occurred during the subsequent events
period. The client’s year-end was 30 June, and the suspected violation occurred on
31 August, the date the restrictions became effective. Possible audit procedures are
as follows:
• Test the covenant restrictions at 31 August. However, since the client does not
have good period-end cutoffs for sales and purchases, Johnson should perform
cutoff procedures at 31 August.
• Test the covenant procedures at 30 June. This may provide some additional
evidence on the reliability of the tests at 31 August.
• Obtain a representation letter from management that the covenant restrictions
were being met.
If Johnson determined that Mother Earth was in violation on 31 August, he could (1)
ask management if they intended to seek a waiver or modification of the loan
restrictions and (2) inquire of the lenders as to whether Mother Earth would be
granted such waiver or modification.
b. In this case, the most appropriate solution is for Johnson to determine if Mother Earth
violated the covenants on 31 August. If so and if the client can obtain a waiver, the
debt should continue to be classified as non-current because no violation was present
at the balance sheet date and the waiver after the balance sheet date cures the
problem. If Johnson determined that a violation had occurred at 31 August, at a
minimum the status of the debt should be disclosed in the notes.
Solution to Internet Assignment
15-13 A review of the relevant sources provides considerable information on its October 2001
restatement. Special purpose entities (SPEs) were used to handle off-balance financing by
Enron. In most cases, it appears as if the SPEs met the accounting rules for not consolidating
such entities. However, it appears that at least one large SPE did not meet the accounting rules
and Andersen claims that they were not told the truth about the outside investments in the SPE.
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CHAPTER 16
AUDITING FINANCING PROCESS: CASH AND INVESTMENTS
Answers to Review Questions
16-1 The reliability of the client’s control activities over cash receipts and cash disbursements
affects the nature and extent of the auditor’s substantive tests of cash balances. The effective
operation of these control activities provides strong evidence that the completeness assertion is
being met. A major internal control procedure that directly affects the audit of cash is the
completion of a monthly bank reconciliation by client personnel who are independent of handling
and recording of cash receipts and cash disbursements. Such bank reconciliations ensure that
the client’s books reflect the same balance as the bank’s after considering reconciling items.
Control can be improved further if an independent party such as the internal auditor reviews the
bank reconciliation.
16-2 A general cash account is the principal cash account for most entities. The major source
of cash receipts for this account is the revenue process, and the major sources of cash
disbursements are the purchasing and human resource management processes. An imprest
bank account contains a stipulated amount of money, and the account is used for limited
purposes.
Imprest accounts are frequently used for disbursing payroll and dividend.
Companies that have multiple locations are likely to have branch accounts. Such accounts
provide the branch with the ability to pay local expenses and to maintain banking relations with
the local community.
An imprest account serves as a clearing account for similar types of direct deposits or
cheques. By separating similar types of payments, the entity facilitates the disbursement of
cash while maintaining adequate control over cash. Use of imprest accounts also minimizes the
time necessary to reconcile the general cash account.
16-3 Because of the residual nature of cash, it does not have a predictable relationship to
other financial statement accounts. As a result, the auditor’s use of analytical procedures for
auditing cash is limited to comparisons with prior years’ cash balances and to budgeted
amounts. This limited use of analytical procedures is normally offset by (1) extensive tests of
controls and/or substantive tests of transactions for cash receipts and cash disbursements or (2)
extensive tests of the entity’s bank reconciliations.
16-4 A cutoff bank statement is obtained to test the reconciling items such as deposits in
transit and outstanding cheques included in the bank reconciliation. For example, the
outstanding cheques returned with the cutoff bank statement are examined for proper payee,
amount, and endorsement.
16-5
Three fraud-related audit procedures for cash are:
• Extended bank reconciliation procedures. These procedures include examining the
disposition of the reconciling items included in the prior months’ reconciliations and
the reconciling items included in the current bank reconciliation.
• Proof of cash. The four-column proof of cash (1) ensures that all cash receipts
recorded in the client’s cash receipts journal were deposited in the client’s bank
account, (2) endures that all cash disbursements recorded in the client’s cash
disbursements journal have cleared the client’s bank account, and (3) ensures that
no bank transactions have been omitted from the client’s accounting records.
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•
Tests for kiting. An interbank transfer schedule is used to test for kiting (see Exhibit
16-3).
16-6 An approach used by auditors to test for kiting is the preparation of an interbank transfer
schedule.
With an interbank transfer schedule the auditor tests the dates of cash
disbursements and the cash receipt for each transfer to assure that the transfer is properly
recorded.
16-7 The main transaction assertions for investments are occurrence, authorization,
completeness, valuation and classification.
The key segregation of duties for investments and the errors or fraud that they can
prevent are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The initiation function should be
segregated from the final approval
function.
Fictitious transactions can be made or securities
can be stolen.
The value-monitoring function should
be segregated from the acquisition
function.
Securities values can be improperly recorded or
not reported to management.
Responsibility for maintaining the
securities ledger should be separate
from that of making entries in the
general ledger.
Concealment of a defalcation that would normally
be detected by reconciliation of subsidiary records
with general ledger control accounts.
Responsibility for custody of securities
should be separate from that of
accounting for the securities.
Theft of securities can be concealed.
16-8 When securities are initially purchased, they are recorded at their acquisition cost. Debt
securities that are to be held to maturity should be valued at their amortized cost. If the
investment value is determined to be permanently impaired, the security should be written down
and a new carrying amount established. IAS 39 Financial Instruments: Recognition and
Measurement includes factors indicating other-than-temporary impairment of the investment.
16-9
are:
The two presentation classification issues that are important for the audit of investments
•
•
Marketable securities need to be properly classified between held-to-maturity
investments, trading investments and available-for-sale financial assets.
The financial statement classification requires that all trading securities be reported
as current assets and held-to-maturity securities and individual available-for-sale
securities be classified as current or non-current assets based on whether
management expects to convert them to cash within the next twelve months.
2
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Solutions to Problems
16-10 The auditor’s internal control questionnaire should include the following additional
questions:
• Does access to the bank safe deposit vault require the signature or presence of two
designated persons?
• Are all individuals who have access to marketable securities bonded?
• Are those who have access to the securities denied access to the accounting
records?
• Does the accounting department keep detailed records of
• Purchases and sales?
• Securities (including number of shares) owned?
• Stock certificate numbers?
• Dividend income?
• Gains and losses?
• Are all securities registered in the name of the company?
• Are all securities periodically inspected?
• Is the inspection performed on a surprise basis?
• Is the physical inventory of securities reconciled with the accounting records?
• Are all purchases and sales of securities executed by the treasurer within the
directives of the investment committee?
• Is the amount of dividends received on individual investments periodically reconciled
to published public records?
• Does the investment committee periodically review compliance with its established
policy?
16-11 The audit plan for auditing Sevcik’s bank balance should include the following steps:
• Review answers to questions on confirmation requests to determine proper
recognition in accounting records and the necessity for financial statement
disclosure.
• Make inquiries as to compensating balances and restrictions.
• Obtain copies of the bank reconciliations as of the balance sheet date and
• Trace the adjusted book balances to the general ledger balances.
• Compare the bank balances to the opening balances on the cutoff bank statements.
• Compare the bank balances to the balances on the confirmations.
• Trace amounts of deposits in transit to the cutoff bank statements and ascertaining
whether the time lags are reasonable.
• Verify the clerical accuracy of the reconciliations.
• Obtain explanation for unusual reconciling items, including cheques drawn to
‘bearer,’ ‘cash,’ and related parties.
• Trace cheques dated prior to the end of the period that were returned with the cutoff
statements to the list of outstanding cheques.
• Investigate outstanding cheques that did not clear with the cutoff bank statements.
• Examine a sample of cheques for payee, amount, date, authorized signatures and
endorsements to determine any deviations from company policy or fraud in the
accounting records.
• Prepare a bank transfer schedule from a review of the cash receipts and
disbursements journals, bank statements and related paid cheques for the last few
days before and the first few days after year-end and
3
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•
•
16-12
Review the schedule to determine that the deposit and disbursement of each transfer
is recorded in the proper period.
Trace incomplete transfers to the schedule of outstanding cheques and deposits in
transit.
a.
b.
c.
d.
e.
f.
4, 9
1, 7, 8, 9, 10
2, 7, 8, 9, 10
5
5, 9
3
16-13 a. The following information is missing:
• The date of purchase of S security.
• The date of purchase and sale of R security.
• Data concerning the accrual and/or receipt of interest due on R to date of sale.
• Data concerning the accrual and/or payment of interest due on S to the date of
purchase.
• Justification for accrual of dividends.
• Accounting treatment of bond discount.
• Data concerning the 31 December, 2005, revenue accruals.
• Data required to evaluate the classification of securities.
b. The following procedures were not noted as having been performed:
• The securities were not physically inspected or confirmed.
• The broker’s advice (or other independent corroborating evidence) verifying the
sale of R was not examined.
• Dividend rates were not verified by reference to public records (e.g. Standard &
Poor’s) of dividend declarations.
• The stated interest rates, maturity dates, and market values were not verified.
• Computations of year-end accruals were not made.
• Not all amounts (e.g. loss on sale of R) were traced to the general ledger.
4
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16-14 a.
Primary Assertion
Objective
4. Existence or occurrence
To determine that the custodian holds the securities as
identified in the confirmation.
5. Completeness
To determine that all income and related collections from
the investments are properly recorded.
6. Valuation or allocation
To determine that the market or other value of the
investments is fairly stated.
7. Authorization and
Presentation and disclosure—
classification, accuracy
To determine that transfers are properly authorized and
that the financial statement presentation and disclosure of
investments is in accordance with the applicable financial
reporting framework and for consistently.
8. Valuation or allocation
To determine that the market or other value of the
investments is fairly stated and the loss is properly
recognized and recorded.
b. Phung should consider applying the following additional substantive auditing
procedures in auditing Vernon’s investments:
• Inspect securities on hand in the presence of the custodian.
• Examine supporting evidence (broker’s advices, etc.) for transactions between
the balance sheet date and the inspection date.
• Obtain confirmation from the issuers or trustees of investments.
• Examine contractual terms of debt securities and preferred stock.
• Determine that the board of directors or its designee properly approved sales and
purchases.
• Examine broker’s advices in support of transactions or confirm transactions with
broker.
• Determine that gains and losses on dispositions have been properly computed.
• Trace payments for purchases to cancelled cheques, and proceeds from sales to
entries in the cash receipts journal.
• Determine that the amortization of premium and discount on bonds has been
properly computed.
• Determine that trading securities and available-for-sale securities are properly
valued and any unrealized gains and losses are properly accounted for.
• Ascertain whether any investments are pledged as collateral or encumbered by
liens and, if so, are properly disclosed.
16-15
a. 5
b. 6
c. 4
Solution to Internet Assignment
5
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16-16 Major companies often hold large amounts of investment securities and give extensive
disclosure in notes to the financial statements.
6
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CHAPTER 17
COMPLETING THE ENGAGEMENT
Answers to Review Questions
17-1 A contingency is a liability that is uncertain because the possible outflow of resources
from the entity will ultimately be resolved when some future event occurs or fails to occur.
Contingencies can be classifies into three categories:
1. Probable: The future event is likely to occur.
2. Neither probable nor remote: The chance of the future event occurring is less than
likely but more than slight (remote).
3. Remote: The chance of the future event occurring is slight.
Examples of contingent liabilities include:
• Pending or threatened litigation.
• Actual or possible claims and assessments.
• Income tax disputes.
• Product warranties or defects.
• Guarantees of obligations to others.
• Agreements to repurchase receivables that have been sold.
17-2 The auditor requests that the lawyer provide the following information on pending or
threatened litigation:
• A list and evaluation of any pending or threatened litigation to which the lawyer has
devoted substantial attention. The client may provide the list.
• A listing of unasserted claims and assessments considered by management to be
probable of assertion and to have more than a remote possibility of unfavourable
outcome.
• A request that the lawyer describes and evaluates the outcome of each pending or
threatened litigation. This should include the progress of the case, the action the
entity plans to take, the likelihood of unfavourable outcome, and the amount or range
of potential loss.
• A request for additions to the list provided by management or a statement that the list
is complete.
• A request that the lawyer comments on unasserted claims where his or her views
differ from management’s evaluation.
• A statement by management acknowledging an understanding of the lawyer’s
professional responsibility involving unasserted claims and assessments.
• A request that the lawyer indicates if his or her response is limited and the reasons
for such limitations.
• A description of any materiality levels agreed upon for the purposes of the inquiry
and response.
An unasserted claim or assessment is one in which the injured party or potential
claimant has not yet notified the entity of a possible claim or assessment. Lawyers may be
reluctant to provide the auditor with information about the unasserted claims because of clientlawyer privilege. Lawyers may also be concerned that disclosure of the unasserted claim may
itself result in lawsuits.
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17-3 Two examples of long-term commitments are the purchase of raw materials or the sale
of products at a fixed price. When the fair market value of the good is less than the purchase
price included in the contract, the entity may have to recognize a loss on a long-term
commitment even though there has been no exchange of goods.
17-4 The two types of subsequent events that require consideration by management and
evaluation by the auditor relevant to financial statement audits are:
1. Events that provide additional evidence about conditions that existed at the date of
the balance sheet and affect the estimates that are part of the financial statement
preparation process. These types of events require adjustment of the financial
statements.
2. Events that provide evidence about conditions that did not exist at the date of the
balance sheet but arose subsequent to that date. These types of events usually
require financial statement disclosure.
Examples of the first type of event or condition are:
• An uncollectible account receivable resulting from continued deterioration of a
customer’s financial condition leading to bankruptcy after the balance sheet date.
• The settlement of a lawsuit after the balance sheet date for an amount different from
the amount recorded in the year-end financial statements.
Examples of the second type of event or condition are:
• Purchase or disposal of a business by the entity.
• Sale of equity capital or bond issue by the entity.
• Loss of the entity’s manufacturing facility or assets resulting from a casualty such as
a fire or flood.
• Changes in tax laws enacted or announced that have a significant effect on financial
statements tax accounts.
• Commencing major litigation arising solely out of events that occurred after the
balance sheet date.
17-5 The period from the date of the auditor’s report to the issuance of the financial
statements is part of the subsequent-events period, but the auditor is not responsible for making
any inquiries or conducting any audit procedures after the date of the audit report. However,
subsequent events may come to the auditor’s attention during this period and require
adjustments (a Type I event) or disclosure (a Type II event) in the financial statements.
17-6 Auditing standards (ISA 520) require that the auditor perform analytical procedures at
the final review stage of the audit. The objective of conducting final analytical procedures near
the end of the engagement is to help the auditor assess the conclusions reached on the
financial statement components and evaluate the overall financial statement presentation.
17-7 The auditor obtains a representation letter in order to corroborate oral representations
made to the auditor and to document the continued appropriateness of such representations.
The representation letter also reduces the possibility of misunderstanding concerning the
responses provided by management to the auditor’s inquiries.
17-8 The main purpose of an engagement quality review is to have an objective evaluation of
the significant judgments made by the engagement team and the conclusions reached in
formulating the auditor’s report. The extent of the review depends on the complexity of the audit
engagement and the risk that the auditor’s report might not be appropriate in the circumstances.
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17-9
Three overall steps in the going-concern evaluation process are as follows:
1. Consider whether the results of audit procedures performed during the planning,
performance, and completion of the audit indicate whether there is significant doubt
about the entity’s ability to continue as a going concern for same period as that used
by management (minimum twelve months from the balance sheet date when
reporting in accordance with IASs/IFRSs).
2. If there is significant doubt, the auditor should obtain information about
management’s plans to mitigate the going-concern problem, including a written
representation of its plans, and assess the likelihood that such plans can be
implemented.
3. If the auditor concludes, after evaluating management’s plans, that there is
significant doubt about the ability of the entity to continue as a going concern, he or
she should consider the adequacy of the disclosure about the entity’s ability to
continue and, if the disclosure is adequate, include an emphasis of matter paragraph
in the audit report.
17-10 The four major categories of events or conditions that may indicate going-concern
problems and examples of each are:
Financial conditions:
• Recurring operating losses.
• Current-year deficit.
• Accumulated deficits.
• Negative net worth.
• Negative working capital.
• Negative cash flow.
• Negative income from operations.
• Inability to meet interest payments.
Other financial difficulties:
• Default on loans.
• Dividends in arrears.
• Restructuring of debt.
• Denial of trade credit by suppliers.
• No additional sources of financing.
Internal matters:
• Work stoppages.
• Uneconomic long-term commitments.
• Dependence on the success of one particular project.
External matters:
• Legal proceedings.
• Loss of a major customer or supplier.
• Loss of a key franchise, license, or patent.
17-11 The following items should be included in the auditor’s communication with those
charged with governance (ISA 260):
• The auditor’s responsibility.
• The planned scope and timing of the audit.
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•
•
•
•
The conduct of and findings from the audit.
Matters required by other ISAs and additional external requirements, and matters
agreed with the entity.
Other matters of which the auditor is aware that the auditor judges to be serious and
relevant to the responsibilities of those charged with governance.
In the case of listed entities, auditor independence (introduced in proposed ISA 260).
Matters required to be communicated to those charged with governance by other ISAs include:
• Fraud the auditor has identified that involves management, employees who have
significant roles in internal control; or others where the fraud results in a material
misstatement in the financial statements (ISA 240).
• Non-compliance with laws and regulations that comes to the auditor’s attention (ISA
250).
• Material weaknesses in the design or implementation of internal control that could
have a material effect on the financial statements that have come to the auditor’s
attention (ISA 315).
• Events or conditions that may cast significant doubt on the entity’s ability to continue
as a going concern (ISA 570, proposed amendment).
• Circumstances that lead to expected modifications to the opinion in the auditor’s
report (proposed ISA 705).
17-12 Generally, when previously issued financial statements contain material misstatements
due to unintentional or intentional actions by management, the financial statements will require
revision.
If the client refuses to cooperate and make the necessary disclosures, the auditor should
notify those charged with governance such as the board of directors and take the following
steps:
1. Notify the client that the auditor’s report must no longer be associated with the
financial statements.
2. Notify regulatory authorities and other persons relying on the auditor’s report that the
auditor’s report can no longer be relied upon.
The practical outcome of these procedures is that the auditor has withdrawn his or her report on
the previously issued financial statements.
Solutions to Problems
17-13 Since the events or conditions that should be considered in the financial accounting for
and reporting of litigation, claims, and assessments are matters within the direct
knowledge, and often, control of management of an entity, management is the primary
source of information about such matters. Accordingly, Harper’s audit procedures with
respect to the existence of loss contingencies arising from litigation, claims, and
assessments should include the following:
• Inquire and discuss with management the policies and procedures adopted for
identifying, evaluating, and accounting for litigation, claims, and assessments.
• Obtain from management a description and evaluation of litigation, claims, and
assessments that existed at the date of the balance sheet being reported on, and
during the period from the balance sheet date to the date the information is
furnished, including an identification of those matters referred to legal counsel, and
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•
•
•
obtain assurances from management, ordinarily in the form of a representation letter,
that they have disclosed all such matters required to be disclosed by the applicable
financial reporting framework.
Examine documents in the client’s possession concerning litigation, claims, and
assessments, including correspondence and invoices from lawyers.
Obtain assurance from management, ordinarily in the form of a representation letter,
that they have disclosed all unasserted claims that the lawyer has advised them are
probable of assertion and must be disclosed in accordance with the applicable
financial reporting framework.
The auditor should request the client’s management to send a letter of inquiry to
those lawyers with whom they consulted concerning litigation, claims, and
assessments.
Examples of other procedures undertaken for different purposes that might also disclose
litigation, claims, and assessments are the following:
• Reading minutes of stockholders, directors, and appropriate committee meetings
held during and subsequent to the period being examined.
• Reading contracts, loan agreements, leases, and correspondence from taxing or
other governmental agencies, and similar documents.
• Obtaining information concerning guarantees from bank confirmation forms.
• Inspecting other documents for possible guarantees by the client.
17-14 The omissions, ambiguities, and inappropriate statements and terminology in Cao’s
letter are as follows:
• The action that Consolidated intends to take concerning each suit (e.g. to contest the
matter vigorously, to seek an out-of-court settlement, or to appeal an adverse
decision) is omitted.
• A description of the progress of each case to date is omitted.
• An evaluation of the likelihood of an unfavourable outcome of each case is omitted.
• An estimate, if one can be made, of the amount or range of potential loss of each
case is omitted.
• The other pending or threatened litigation on which Young was consulted is not
identified and included.
• The unasserted claims and assessments probable of assertion that have more than a
remote possibility of an unfavourable outcome are not identified.
• Consolidated’s understanding of Young’s responsibility to advise Consolidated
concerning the disclosure of unasserted possible claims or assessments is omitted.
• Materiality (or the limits of materiality) is not addressed.
• The reference to a limitation on Young’s response due to confidentiality is
inappropriate.
• Young is not requested to identify the nature of and reasons for any limited response.
• Young is not requested to include matters that existed after 31 December 2005 up to
the date of Young’s response.
• The date by which Young’s response is needed is not indicated.
• The reference to Young’s response possibly being quoted or referred to in the
financial statements is inappropriate.
• Vague terminology such as ‘some chance’ is included where ‘possible’ is more
appropriate.
• There is no inquiry about any unpaid or unbilled charges, services, or disbursements.
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17-15 a. For the financial statement audit, the two types of subsequent events that require
Namiki’s consideration and evaluation are:
• Events that provide additional evidence concerning conditions that existed at the
balance sheet date and affect the estimates inherent in the process of preparing
financial statements. This type of subsequent event requires that the financial
statements be adjusted for any changes in estimates resulting from the use of
such additional evidence.
• Events that provide evidence concerning conditions that did not exist at the
balance sheet date but arose subsequent to that date. Such events result in
financial statement disclosure.
b. The auditing procedures Namiki should consider performing to gather evidence
concerning subsequent events include the following:
• Review procedures management has established to ensure that subsequent
events are identified.
• Compare the latest available interim statements with the financial statements
being audited.
• Ascertain whether the interim statements were prepared on the same basis as the
audited financial statements.
• Inquire whether any contingencies or commitments existed at the balance sheet
date or the date of inquiry.
• Inquire whether there was any significant change in the equity capital, long-term
debt, or working capital to the date of inquiry.
• Inquire about the current status of items in the audited financial statements that
were accounted for on the basis of tentative, preliminary, or inconclusive data.
• Read or inquire about the minutes of meetings of stockholders or the board of
directors.
• Inquire of the client’s legal counsel concerning litigation, claims, and
assessments.
• Obtain a management representation letter, dated as of the date of Namiki’s audit
report, as to whether any subsequent events would require adjustment or
disclosure.
• Make such additional inquiries or perform such additional procedures Namiki
considers necessary and appropriate.
• Examine and/or inquire about findings including in internal audit reports completed
after year end.
17-16 1. The explosion in Agronowitz’s plant that led to the uncollectibility of Scornick
Company’s accounts receivable was an event whose conditions did not exist at the
balance sheet date. Thus, the event requires disclosure only in the 2005 financial
statements.
2. The tax court ruling in favour of Scornick Company is an event whose conditions
existed at the balance sheet date and which involves the revision of an estimate. The
2005 financial statements should be adjusted to reflect the favourable ruling.
3. The sale of Scornick’s Manufacturing Division is an event whose conditions did not
exist at the balance sheet date. This event requires disclosure in the 2005 financial
statements.
4. This is not an event that is considered a subsequent event for financial statement
purposes.
5 This is not an event that is considered a subsequent event for financial statement
purposes.
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17-17 a. The purposes of obtaining a written management representation letter are to:
• Confirm the oral representations given to the auditor.
• Indicate and document the continuing appropriateness of management’s
representations.
• Reduce the possibility of misunderstanding concerning the matters that are the
subject of the representations.
• Complement the other auditing procedures by corroborating the information
discovered in performing those procedures.
• Obtain evidence concerning management’s future plans and intentions (e.g. when
refinancing debt or discontinuing a line of business).
b. The representation letter should be addressed to the auditor and dated as of the date
of the auditor’s report. The letter should be signed by members of management
whom the auditor believes are responsible for and knowledgeable, directly or through
others in the organization, about the matters covered by the representation. Their
refusal to sign the letter would constitute a limitation on the scope of the audit
sufficient to preclude an unmodified opinion and affect the auditor’s ability to rely on
other management representations. The refusal is ordinary sufficient to cause an
auditor to disclaim an opinion or withdraw from the engagement.
c. Obtaining a management representation letter does not relieve an auditor of any other
responsibility for planning or performing an audit. Accordingly, an auditor should still
perform all the usual tests to corroborate representations made by management.
17-18 Other matters that Heinrich’s representation letter should specifically confirm include
whether or not:
• Management acknowledges responsibility for the fair presentation in the financial
statements of financial position, results of operations, and cash flows in accordance
with the National Financial Reporting Framework.
• All material transactions have been properly reflected in the financial statements.
• There are other material liabilities or gain or loss contingencies that are required to be
accrued or disclosed.
• The company has satisfactory title to all owned assets, and whether there are liens or
encumbrances on such assets or any pledging of assets.
• There are related-party transactions or related amounts receivable or payable that
have not been properly disclosed in the financial statements.
• The company has complied with all aspects of contractual agreements that would
have a material effect on the financial statements in the event of non-compliance.
• Events have occurred subsequent to the balance sheet date that would require
adjustment to, or disclosure in, the financial statements.
• The auditor has been advised of all actions taken at meetings of stockholders, the
board of directors, or other similar bodies that may affect the financial statements.
• All financial records and data were made available for the auditor.
• Management acknowledges its responsibility for the design and implementation
internal control to prevent and detect fraud.
• Management has disclosed to the auditor the results of its assessment of the risk that
the financial statements may be materially misstated as a result of fraud.
• Management has knowledge of any allegations of fraud or suspected fraud affecting
the entity’s financial statements communicated from employees, former employees,
analysts, regulators, or others.
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• Management is aware of fraud that could have a material effect on the financial
statements or that involve management or employees who have significant roles in
the internal control system.
• Receivables recorded in the financial statements represent valid claims against
debtors for sales and have been appropriately reduced to their estimated net
realizable value.
• Provision, when material, has been made to reduce excess or obsolete inventories to
their estimated net realizable value.
• Inventory quantities at the balance sheet dates were determined from physical counts
taken by competent employees at various times during the year.
• The effects of the uncorrected financial statements misstatements summarized in the
schedule (accompanying the representation letter) are immaterial, both individually
and in the aggregate, to the financial statements taken as a whole.
• Appropriate provision has been made for any material loss to be sustained in the
fulfilment of, or from inability to fulfil, any sales commitments.
• Appropriate provision has been made for any material loss to be sustained as a result
of purchase commitments for inventory quantities in excess of normal requirements
or at prices in excess of the prevailing market prices.
17-19
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
E
M
L
G
M
H
C
K
E
M
O
I
E
E
E
E
B
M
L
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Solutions to Discussion Cases
17-20 a. At the international level the International Accounting Standard (IAS) 37 ‘Provisions,
Contingent Liabilities and Contingent Assets’ prescribes the accounting and
disclosure for liabilities, including liabilities that will be resolved by the occurrence or
non-occurrence of some future events (i.e., contingencies). Application of IAS 37 to
contingencies would imply that the auditor must decide whether an estimated loss
from the contingency is probable and estimable, probable but not estimable, neither
probable nor remote, or remote. Since the NEPA has not initiated a lawsuit or other
regulatory action against Ceramic Crucibles, the potential loss is an unasserted claim.
To reach a decision in this case, it is necessary to consider whether the facts would
lead to a conclusion about the probability that a claim will be asserted against
Ceramic Crucibles and, if so, whether the amount of the clean-up cost is reasonably
estimable.
An argument can be made that a claim will not occur or not have a significant
effect on Ceramic Crucibles’s financial statements. First, the fact that Ceramic
Crucibles has been named as one of the ‘potentially responsible parties’ (PRP) with
two other companies may not lead to a claim against the company. This line of
reasoning argues that the Red River site was placed on the National Priorities List
only because each region must have a site on the list, not because of the extent of
the pollution. Second, the rating of the Red River site is considerably lower than the
ratings of other sites on the list. Third, there are two viable PRPs who are responsible
for the vast majority of the contaminants. Finally, based on the fact that the NEPA
has paid most of the costs of pollution clean-ups and only a fraction of the costs of
pollution clean-ups have been borne by industry, it is quite likely that the company
may never have to pay. An unfavourable outcome under these facts might be
considered remote, and no disclosure would be required.
An argument can also be made that, based on the current evidence of pollution on
the site, and the fact that once the NEPA has put a site on the National Priorities List
and has authorized an investigation of the site, it is unlikely that they will not assert a
claim. In this case, it is considered probable that a claim will be asserted and there is
a more than a remote that the outcome will be unfavourable. However, Ceramic
Crucibles’s financial position does not appear to be threatened by potential action
because its pollution levels are significantly below the levels of others, the other PRPs
are capable of paying their share of potential fines, the company no longer uses lead
in its production process, its past use of lead met the national food quality authorities
requirements, and no waste water has been discharged since the company acquired
the property. Ceramic Crucibles could also sue the prior owners of the property for
their share of the damages should there be an adverse outcome to the investigation.
b. In assessing the materiality of an uncertainty it must be recognized that some
uncertainties are unusual in nature or infrequent in occurrence and thus more closely
related to financial position than to normal, recurring operations (e.g. litigation related
to alleged violations of fair competition or employments regulations). In such
instances the auditor should consider the possible loss in relation to shareholder’s
equity and other relevant balance sheet components such as total assets, total
liabilities, current assets, and current liabilities.
The potential loss of between €10 million to €13 million represents a reduction in
stockholders’ equity of 4.5 per cent to 7.0 per cent. These amounts might be
9
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considered material to the financial statements and thus require disclosure by the
client in the notes. However, considering that the likelihood of the claim is remote and
that Ceramic Crucibles (or NEPA) can take action against the other PRPs, it is not
likely that an unfavourable outcome would be material. It also does not appear that
an unfavourable outcome would have an adverse affect on the company’s financial
position.
c. The auditor could obtain and examine a number of additional pieces of evidence,
including the following:
Copies of any public documents (e.g. the report rating the site as 8.3) that led to
the site being added to the National Priorities List.
• Financial information on the other PRPs.
• Information on Ceramic Crucibles’s change to lead-free mud in its crucibles.
• The affidavits from Ceramic Crucibles’s employees on the discharges into the
levee.
• Any environmental engineering studies conducted by Ceramic Crucibles.
The auditor would obtain representations from management concerning its
estimate of the likelihood of a materially adverse outcome. This should be included in
the management representation letter.
•
d. It is highly unlikely that the investigation would affect the auditor’s report.
Thus, a
standard audit report with an unmodified opinion would be issued.
17-21 This case presents a realistic situation that can arise on an audit engagement. The main
issue of the case is whether the auditor needs to require the client to make adjustments
to the financial statements for possible misstatements that have been identified during
the audit. These proposed adjustments can result in conflicts between the auditor and
client.
a. The issue is the possible obsolescence of the specialized computer components for
the special-order optical scanner. The auditors identified these components as
possible obsolete items in 2004. The client explained that the items could be sold
during the next year without a loss. The components were not sold during 2005, and
there appear to be no prospects of a future sale. Based on these facts, the auditor
should insist that the components be written down to their fair market value, which
appears to be zero.
b. In 2004, the auditors waived the adjustment of €20,000 for accrued vacation pay
based on materiality considerations. By 2005, the amount of accrued vacation pay
amounted to €300,000. Since accounting standards require accrual of such expense
and the amount is material, the auditor should insist on accruing the executives’
vacation pay.
c. It is difficult to provide detailed guidance on how Schmidt should handle the client’s
demands. Schmidt should try to explain to Adams that accounting standards require
that such adjustments are required to make the financial statement present fairly.
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She should also point out that shareholders might react very negatively if they
discovered that management was manipulating earnings from period to period in
order to maintain the stock’s price. The potential for stockholders’ lawsuits could be
raised. However, if Schmidt believes that both adjustments are necessary, she must
require the client to make the adjustments or resign from the engagement.
Solutions to Internet Assignments
17-22 a. It is possible to get information on these frauds by searching the Internet using a
search engine (e.g. Google.com). The company name as well as terms like
‘accounting fraud’ and ‘accounting irregularities’ can be used in the search. News
sites and web sites of business journals are also a good source of information.
However, to retrieve the articles, there may be a fee. The SEC’s EDGAR database
is a free site and can be used to research specific companies registered in the US
(www.sec.gov).
b. Various news and search engine web sites can be used to find information on recent
accounting frauds. Documents from legal cases and bankruptcy proceedings may
also be a source of good information.
17-23 Web sites of stock exchanges and supervisory bodies may be a source for finding
situations where the auditor has withdrawn an audit report on a company. In addition, students
may find information on news sites. For companies registered in the US the SEC’s EDGAR
database search engine is a good source of information (www.sec.gov).
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CHAPTER 18
REPORTS ON AUDITED FINANCIAL STATEMENTS
Answers to Review Questions
18-1 The nine elements of the audit report with an unmodified opinion on the financial
statements are: (1) the title, (2) the addressee, (3) the introductory paragraph, (4)
management’s responsibility, (5) auditor’s responsibility, (6) auditor’s opinion, (7) auditor’s
signature, (8) the date of the report, and (9) auditor’s address.
18-2 An emphasis of matter paragraph does not affect the auditor’s opinion because it can
only be included in the audit report if the matter is presented or disclosed in the financial
statements in accordance with the applicable financial reporting framework. An other matters
paragraph does not affect the auditor’s opinion because it relates to matters other than those
required to be presented or disclosed in the financial statements.
18-3 An emphasis of matter paragraph is required when a material uncertainty about the
entity’s ability to continue as a going-concern exists. Further, when the matter is both unusual
and of fundamental importance to the user’s understanding of the financial statements, the
following circumstances would require an emphasis of matter paragraph:
• Significant uncertainties. A significant uncertainty may be related to the future
outcome of major litigation or regulatory action. An example would be that a
regulatory agency requires a company to recall a major product for safety reasons.
• Significant and unusual related party transactions. An example could be a sale of a
company’s building to the CEO.
• Early application of a new accounting principle. Early application means application
before a new accounting principle or standard is required.
• A subsequent event disclosed in the financial statements. An example would be a
purchase or disposal of a business by the entity after the balance sheet date that
results in disclosure in the financial statements.
• A matter such as a major catastrophe, which is disclosed in a note to the financial
statements, that has had, or continues to have, a significant effect on the entity’s
business or operations. An example would be the destruction of a major production
plant by a fire.
18-4 An example of a client-imposed scope limitation is where a client requests that the
auditor not confirm accounts receivable because of concerns about creating conflicts with
customers over amounts owed. An example of a circumstances-imposed scope limitation is
when the auditor is not engaged to conduct the audit until after year-end. Under such
circumstances, the auditor may not be able to observe inventory. Auditors should be
particularly cautious when a client places a limit on the scope of the engagement because the
client may be trying to prevent the auditor from discovering material misstatements. Auditing
standards suggest that when restrictions imposed by the client significantly limit the scope of the
engagement, the auditor should disclaim an opinion on the financial statements.
18-5
The three types of audit reports with modified opinions are:
• Audit Reports with a Qualified Opinion. The auditor’s opinion is qualified because of
either a scope limitation or a departure from the applicable financial reporting
framework, but overall the financial statements present fairly.
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•
•
Audit Reports with a Disclaimer of Opinion. The auditor disclaims an opinion on the
financial statements because there is insufficient appropriate evidence to form an
opinion on the overall financial statements.
Audit Reports with an Adverse Opinion. The auditor’s opinion states that the financial
statements do not present fairly in accordance with the applicable financial reporting
framework because the departure materially affects the overall financial statements.
18-6 The concept of materiality plays a major role in the auditor’s choice of audit reports.
Conditions that may lead to a departure from the applicable financial reporting framework
include circumstances where a departure from the applicable financial reporting framework is
evident or where an auditor is not able to gather sufficient appropriate evidence to become
reasonably assured that there is no material misstatement with respect to a particular
management assertion. If the condition (e.g. scope limitation or departure from the applicable
financial reporting framework) that might lead to the departure is judged by the auditor to be
immaterial, then a standard audit report with an unmodified can be issued. As the materiality of
the condition increases, the auditor must judge the effect of the item on the overall financial
statements. If the condition is material but the overall financial statements still present fairly, the
auditor should issue a qualified opinion. If the effect of the condition is so significant that the
overall financial statements are affected, the auditor should issue a disclaimer or an adverse
opinion as appropriate, or may consider withdrawing from the engagement.
18-7 The auditor should issue an audit report with an unmodified opinion on the 2004 financial
statements and a modified report on the 2005 financial statements because the current year is
not in accordance with the applicable financial reporting framework. The inappropriate
accounting for the lease transaction should be disclosed in the audit report. The opinion on the
2005 financial statements would not be adverse because, while the misstatement is material, it
is not highly material or pervasive.
18-8 The auditor’s reporting responsibility is restricted to information identified in the auditor’s
report, and he or she has no obligation to perform any audit procedures to corroborate the other
information included in an entity’s annual report. (In some jurisdiction the auditor is obliged to
report, in addition to express an opinion on the financial statements, specifically on certain of the
other information published in a document that contains the audited financial statements. In
such circumstances the auditor should apply necessary procedures to assure the relevant other
information and issue an audit report as appropriate.) However, auditing standards (ISA 720)
requires that the auditor read the other information and consider whether such information is
consistent with the information contained in the audited financial statements.
18-9 If the auditor determines that other information contained with audited financial
statements is incorrect, the auditor should request that the client correct the other information. If
the other information is not revised, the auditor should include an other matters paragraph in the
audit report, withhold the report, or withdraw from the engagement.
18-10 Examples of special reports include reports on:
• Financial statements prepared on an other comprehensive basis of accounting to
meet the needs of specific users.
• Components (a single financial statement, specified elements, accounts, or items) of
financial statements.
• Compliance with contractual agreements related to audited financial statements.
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18-11
Three bases for OCBOA financial statements are:
• Regulatory basis.
• Tax basis.
• Cash basis.
It is important that OCBOA financial statements be properly titled so that they are not confused
with financial statements prepared in accordance with financial reporting framework designed to
meet the common information needs of a wide range of users (i.e. ‘general purpose financial
statements’).
Solutions to Problems
18-12 a. The auditor should issue an audit report with a qualified opinion if the applicable
financial reporting framework such as IFRSs, requires including a statement of cash
flows among the financial statements. The auditor is not required to prepare the
statement of cash flows for disclosure in the audit report.
b. This situation suggests that the client has determined that the uncertainty is probable
but the amount of damages is not estimable. The company’s disclosure approach is
not in accordance with a financial reporting framework such as IFRSs because such
contingencies must be disclosed in the notes to the financial statements. A
departure from the applicable financial reporting framework such as this one requires
either an audit report with a qualified or an adverse opinion, depending on the
materiality of the item in question. In this case the potential settlement is likely to be
very large given the proportions of the tragedy in terms of human loss and suffering.
In addition, the tragedy may well threaten the company’s ability to be involved in
similar projects in the future. Thus, an adverse opinion is very likely the most
appropriate response.
c. If the auditor is satisfied that the controller’s motivation for not sending confirmation
is appropriate, the auditor should issue an audit report with a qualified opinion for a
scope limitation due to a lack of evidence on the accounts receivable balance. If the
question had indicated that the accounts receivable balance was highly material, an
audit report with a disclaimer of opinion would have been the appropriate response.
d. Since the auditor is satisfied about the inventory balance using alternative audit
procedures, a standard audit report with an unmodified opinion can be issued. The
alternative audit procedures would normally include a physical count subsequent to
year end and reconciliation to the balance at the end of the reporting period.
e. The client’s failure to disclose the related-party transaction means that the financial
statements do not comply with a financial reporting framework such as IFRSs. Since
the client fails to disclose the related-party transaction, the auditor should issue an
audit report with a qualified or adverse opinion depending on the materiality of the
matter.
18-13 a. The auditor should issue a standard audit report with an unmodified opinion. As long
as this uncertainty is properly disclosed or accounted for in accordance with the
applicable financial reporting framework, the auditor need not modify the opinion. In
this case, a negative outcome for this uncertainty appears to be remote. Therefore,
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the client is not required by a financial reporting framework such as IFRSs to
disclose the uncertainty in the financial statements.
b. This is a significant and unusual related party transaction that would require an audit
report with an emphasis of matter paragraph (proposed ISA 706).
c. A scope limitation exists because you have been unable to obtain reasonable
assurance that all cash sales have been properly recorded. Thus, you should issue
an audit report with a qualified opinion or a disclaimer of opinion depending on the
materiality of the matter.
d. This is an early application of a new accounting standard that would require an audit
report with an emphasis of matter paragraph (proposed ISA 706).
e. Assuming that the error is properly accounted for by the client (including any required
restatement of the prior year financial statements), you should issue a standard audit
report with an unmodified opinion.
f.
If the information in the management’s report is not revised, the auditor should
include an other matters paragraph in the audit report describing the material
inconsistence in the management’s report.
g. If the client refuses to make the adjustment to the loan-loss reserve, the auditor
should issue an audit report with a qualified or adverse opinion because the financial
statements will not be in accordance with the financial reporting framework. The
auditor may also have significant doubt about the entity’s ability to continue as a
going-concern, which could result in the addition of an emphasis of matter paragraph
to the audit opinion to disclose the going-concern issues. If the auditor concludes
that there is a going-concern problem and the client refuses to disclose the issue in
the notes to the financial statements, the auditor’s opinion will be adverse.
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18-14
INDEPENDENT AUDITOR’S REPORT
To the Shareholders of Devon Worldwide
We have audited the accompanying financial statements of Devon Worldwide, which comprise
the balance sheet as at 31 December 2006, and the income statements, statements of changes
in equity and cash flow statements for the period ended 31 December 2006, and a summary of
significant accounting policies and other explanatory notes. The financial statements of Devon
Worldwide as of 31 December 2005, and for the year then ended, were audited by other
auditors whose report dated 31 March 2006, expressed an unmodified opinion on these
statements.
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. This responsibility
includes: designing, implementing and maintaining internal control relevant to the preparation
and fair presentation of financial statements that are free from material misstatement, whether
due to fraud or error; selecting and applying appropriate accounting policies; and making
accounting estimates that are reasonable in the circumstances.
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 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 misstatement 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 presentation 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.
Basis for Qualified Opinion
Devon Worldwide has excluded, from property and debt in the accompanying balance sheet,
certain lease obligations that, in our opinion, should be capitalized in accordance with
International Financial Reporting Standards. If these lease obligations were capitalized,
property would be increased by €312,000 and long-term debt by €387,000, and retained
earnings would be decreased by €75,000 as of 31 December 2006. Additionally, net income
and earnings per share would be decreased by €75,000 and €.75, respectively, for the year
then ended.
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Qualified Opinion
In our opinion, except for the possible effects of the matter described in the Basis for Qualified
Opinion paragraph, the financial statements present fairly, in all material respects, the financial
position of Devon Worldwide as of 31 December 2006, and of its financial performance and its
cash flows for the year then ended in accordance with International Financial Reporting
Standards.
Rao
Rao, Independent Auditor
28 February 2007
PO Box xxx
City
18-15
INDEPENDENT AUDITOR’S REPORT
To the Board of Trustees of Modern Museum
We have audited the accompanying statements of assets, liabilities, and fund balances arising
from modified cash transactions of Modern Museum as of 31 December 2006 and 2005, and
the related statements of support, revenue, and expenses and changes in fund balances
modified cash basis and changes in financial resources-modified cash basis for the years then
ended.
Management’s Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation on a modified cash basis.
This responsibility includes: designing, implementing and maintaining internal control relevant to
the preparation and fair presentation of financial statements that are free from material
misstatement, whether due to fraud or error; selecting and applying appropriate accounting
policies; and making accounting estimates that are reasonable in the circumstances.
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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 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 misstatement 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 presentation 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.
As described in Note X, these financial statements were prepared on the basis of modified cash
receipts and disbursements.
Opinion
In our opinion, the financial statements present fairly, in all material respects, the assets,
liabilities, and fund balances arising from modified cash transactions of Modern Museum at 31
December 2006 and 2005, and its support, revenue, and expenses and the changes in its fund
balances and changes in financial resources for the years then ended, on a modified cash basis
of accounting as described in Note X.
Brown & Brown
Brown
Brown, Independent Auditor
12 March 2007
PO Box xxx
City
18-16
INDEPENDENT AUDITOR’S REPORT
To the Board of Directors of Kim Company
We have audited the accompanying financial statements of Kim Company, which comprise the
balance sheet as at 31 December 2006 and 2005, and the income statements, statements of
changes in equity and cash flow statements for the years then ended, and a summary of
significant accounting policies and other explanatory notes.
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. This responsibility
includes: designing, implementing and maintaining internal control relevant to the preparation
and fair presentation of financial statements that are free from material misstatement, whether
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due to fraud or error; selecting and applying appropriate accounting policies; and making
accounting estimates that are reasonable in the circumstances.
Auditor’s Responsibility
Our responsibility is to express an opinion on these financial statements based on our audit.
Except for the matter described in the Basis for Qualified Opinion paragraph, 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 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 misstatement 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 presentation 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.
Basis for Qualified Opinion
We did not observe the counting of the physical inventory as of 31 December 2004, since that
date was prior to the time we were engaged as auditors for the Company, and we were unable
to satisfy ourselves regarding inventory quantities by means of other auditing procedures.
Inventory amounts as of 31 December 2004 enter into the determination of net income and cash
flows for the year ended 31 December 2004.
Because of the matter discussed in the preceding paragraph, the scope of our work was not
sufficient to enable us to express, and we do not express, an opinion on the results of
operations and cash flows for the year ended 31 December 2005.
Opinion
In our opinion the financial statements present fairly, in all material respects, the financial
position of Kim Company as of 31 December 2006 and 2005, and of its financial performance
and its cash flows for the year ended 31 December 2006 in accordance with International
Financial Reporting Standards.
Friday & Co.
Friday
Friday, Independent Auditor
11 March 2007
PO Box xxx
City
Solution to Discussion Case
18-17 a. International Accounting Standard 1 ‘Presentation of Financial Statements’ requires
management to make an assessment of an enterprise’s ability to continue as a
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going-concern. Financial statements shall be prepared on a going-concern basis
unless management either intends to liquidate the entity or to cease trading, or has
no realistic alternative but to do so. When management is aware, in making its
assessment, of material uncertainties related to events or conditions that may cast
significant doubt upon the entity’s ability to continue as a going-concern, those
uncertainties shall be disclosed.
In assessing whether the going-concern
assumption is appropriate, management takes into account all available information
about the future, which is at least, but is not limited to, twelve months from the
balance sheet date.
Auditing standards provide guidance to the auditor for evaluating an entity’s
ability to continue as a going-concern. Auditing standards (ISA 570) require the
auditor to consider the appropriateness of management’s use of the going-concern
assumption in the preparation of the financial statements, and to consider whether
there are material uncertainties about the entity’s ability to continue as a goingconcern that need to be disclosed in the financial statements. In performing audit
procedures throughout the audit the auditor remains alert for audit evidence of
events or conditions and related business risks which may cast significant doubt on
the entity’s ability to continue as a going-concern, such as the following:
• Negative trends.
• Other indications of possible financial difficulties.
• Internal matters.
• External matters that have occurred.
Once conditions or events that may indicate a going-concern problem have been
identified, the auditor should consider how management plans to overcome the
adverse effects of the conditions and events. The auditor should consider the
following:
• Plans to dispose of assets.
• Plans to borrow money or restructure debt.
• Plans to reduce or delay expenditures.
• Plans to increase ownership equity.
b. In this case the auditor knows that for the year ended 31 March 2005, the previous
auditor had determined that there was significant doubt about Paper Packaging’s
ability to continue as a going-concern and consequently the auditor’s report included
an emphasis of matter paragraph discussing the going-concern uncertainty.
It appears, then, that the burden of proof has shifted. The auditor needs to
evaluate whether the conditions and events that caused the auditor to use an
emphasis of matter paragraph in the report for a going-concern uncertainty continue
to exist or whether the auditor can be satisfied that there has been sufficient
improvement in Paper Packaging’s financial condition that there is no longer a
significant doubt about the company’s ability to continue as a going-concern.
c. In making the determination of whether to use an emphasis of matter paragraph, the
auditor must consider how successful management has been in overcoming the
conditions that existed at 31 March 2005. In this case the following positive events
have occurred since the 31 March 2005, year-end:
• The company has renegotiated its 2000 credit agreement. That agreement has a
ten-year term, requires no repayment of principal during the first two years, and
provides for 8 per cent annual interest for the term of the agreement.
• The arbitration proceedings were resolved in 2006.
• The company settled all outstanding legal actions in 2006.
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Most of the company’s tax issues have been resolved, and those still pending are
expected to result in a cash inflow to the company.
Nevertheless, despite the fact that most of the adverse conditions that existed at
the 2005 year-end have been resolved favorably, at 31 March 2006, the company
continues to be in default on €4.6 million of the debentures due in 2005. Based on
that fact alone, there may be sufficient grounds for including an emphasis of matter
paragraph for a going-concern uncertainty in the report on the 31 March 2006.
On the other hand, there are some positive trends that should be considered.
For example, the company had a cash balance of €5.5 million at year-end and
expects to generate a net cash flow of €3.2 million in the upcoming fiscal year.
Further, Paper Packaging’s plan for 2007 indicates that the company expects its
earnings before income taxes to be €1.5 million.
•
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CHAPTER 19
PROFESSIONAL ETHICS, INDEPENDENCE AND QUALITY CONTROL
Answers to Review Questions
19-1 The three theories of ethical behaviour are (1) utilitarianism, (2) rights-based approach,
and (3) justice-based approach. Utilitarian theory recognizes that decision-making involves
trade-offs between the benefits and burdens of alternative actions, and it focuses on the
consequences of an action on the individuals affected. The theory proposes that the interests of
all parties affected, not just one’s self-interest, should be considered. The theory of rights
assumes that individuals have certain rights and other individuals have a duty to respect those
rights. Thus, a decision maker who follows a theory of rights should undertake an action only if
it does not violate the rights of any individual. The theory of justice is concerned with issues
such as equity, fairness and impartiality. Decisions made within this theory should lead to a fair
and equitable distribution of resources among those individuals or groups affected.
19-2
The six stages of ethical development are:
Stage I: The individual’s actions are judged in terms of their physical consequences,
such as avoidance of punishment.
Stage II: The individual is aware of others' needs, but satisfaction of the individual’s
own needs is the basic motivation for action.
Stage III: The individual attempts to conform to group norms. The other’s view of the
situation is considered, and conflicts are resolved through the use of these
norms.
Stage IV: The individual is concerned about order in society and its rules. The
individual uses the laws and rules for guidance in conflict situations.
Stage V: The individual views social contracts and mutual obligations as important.
Differences in conflict situations are resolved impartially and with
consideration of everyone’s interests.
Stage VI: The individual bases actions on universal moral and ethical principles (such
as justice, equality, and dignity) that apply to all individuals and groups.
Research indicates that auditors typically operate at stages III and IV in making professional
ethics judgments, but this depends on career stage and other factors. Hopefully future
accounting professionals will operate at higher stages!
19-3 In the 1990s regulators as well as the profession felt a need to clarify the varied and often
inconsistent meanings the profession, regulators, and the literature hade assigned to
independence, and start mapping out an approach to independence issues from here. The
effectiveness of the traditional detailed rules approach to regulation of independence had come
into question. Thus, both the profession and regulators were in search of an articulated, wellreasoned, and robust operational framework for resolving independence issues. Such
framework would serve as a foundation for the regulators to develop independence rules and
assist other independence decision makers such as audit firms and auditors in analyzing and
reaching conclusions about what is acceptable behaviour in the absence of specific authoritative
rules.
19-4
The four key steps are:
• Identify threats to independence.
• Evaluate the significance of the threats.
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•
•
Identify and evaluate the effectiveness of existing and potential safeguards against
the threats.
Apply appropriate safeguards to bring independence risk to an acceptable low level;
or eliminate the activity or relationship creating the threats, or do not accept or
terminate the assurance engagement.
19-5 Independence affects auditor objectivity because independence means absence of
interests that may compromise objectivity.
19-6
The five principles in The IFAC Code of Ethics are:
Integrity. A professional accountant should be straightforward and honest in all
professional and business relationships.
Objectivity. A professional accountant should not allow bias, conflict of interest, or
undue influence of others to override professional or business judgments.
Professional competence and due care. A professional accountant has a continuing
duty to maintain professional knowledge and skill at the level required to ensure that
a client or employer receives competent professional service based on current
developments in practice, legislation and techniques. A professional accountant
should act diligently and in accordance with applicable technical and professional
standards when providing professional services.
Confidentiality.
A professional accountant should respect the confidentiality of
information acquired as a result of professional and business relationships and
should not disclose any such information to third parties without proper and specific
authority unless there is a legal or professional right or duty to disclose. Confidential
information acquired as a result of professional and business relationships should
not be used for the personal advantage of the professional accountant or third
parties.
Professional behaviour. A professional accountant should comply with relevant laws
and regulations and should avoid any action that discredits the profession.
19-7 Circumstances in which confidential client information can be disclosed under the IFAC
Code of Ethics without the client’s permission:
• Disclosure is required by law, for example
•
Production of documents or other provision of evidence in the course of legal
proceedings.
•
Disclosure to the appropriate public authorities of infringements of the law that
come to light.
• There is a professional duty or right to disclose, when not prohibited by law.
•
To comply with the quality review of a member body or professional body.
•
To respond to an inquiry or investigation by a member body or regulatory body.
•
To protect the professional interests of a professional accountant in legal
proceedings.
•
To comply with technical standards and ethics requirements.
19-8 The Code states that professional accountants should not (1) make exaggerated claims
for the services they are able to offer, (2) make exaggerated claims for the qualifications they
possess or experience they have gained; or (3) make disparaging references or unsubstantiated
comparisons to the work of others.
19-9 One circumstance may be associated with more than one category of threat.
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Examples of self-interest threats and applicable safeguards
• A team member has a financial interest in the client.
• Disclose to those charged with governance the extent and nature of the financial
interest.
• Dispose part of or the complete financial interest.
• Potential employment of team member to a client.
• Restrict the member’s responsibilities on the engagement.
• Remove the member from the team.
• Recruiting client senior management.
• Restrict the services to review the professional qualifications of applicants and
provide advice on their suitability for the post.
• Restrict the services to produce a short-list of candidates for interview, provided it
has been drawn up using criteria specified by the client.
Examples of self-review threats and applicable safeguards
• Temporary staff assignments to a client.
• Ascertain that the staff providing the assistance is not given audit responsibility for
any function or activity that they performed or supervised during their temporary
staff assignment.
• Disclose to those charged with governance the extent and nature of the temporary
staff assignment.
• Preparing accounting records for the client.
• Ascertain that all underlying assumptions are originated and approved by the
client.
• Restrict the involvement to accounting services of routine and mechanical nature.
• Provision of IT system services to the client.
• Ascertain that the client makes all management decisions with respect to the
design and implementation process.
• Ascertain that the client evaluates the adequacy and results of the design and
implementation of the system
Examples of advocacy threats and applicable safeguards
• Provision of legal services to the client.
• Consult an independent third party, such as an audit committee, a professional
regulatory body or another professional accountant.
• Ascertain that members of the team are not involved in providing the legal service.
• A contingent fee charged by a firm for a non-assurance service provided to a client.
• Disclose to those charged with governance the extent and nature of the fee
charged.
• Review of the final fee by an unrelated third party.
• Auditor is assisting the client in resolving a tax dispute.
• Restrict the nature of the involvement.
• Consult an independent third party, such as an audit committee, a professional
regulatory body or another professional accountant.
Examples of familiarity threats and applicable safeguards
• Using the same senior personnel on the engagement over a long period of time.
• Engagement quality control review.
• Rotate senior personnel on the engagement.
• A member of the engagement team has a family relationship with client personnel.
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• Reduce the member’s responsibilities on the team.
• Remove the member from the team.
• A member of the engagement team has served with the client.
• Involve an additional professional accountant to review the work done by the
member.
• Discuss the issue with those charged with governance.
Examples of intimidation threats and applicable safeguards
• The client threatens the auditor with litigation.
• Disclose to those charged with governance the extent and nature of the threatened
litigation.
• Involve an additional professional accountant in the firm who was not a member of
the team to review the work done.
• An audit firm is threatened with replacement over a disagreement about an auditee’s
application of an accounting principle.
• Discuss the issue with those charged with governance.
• Involve an additional professional accountant to review the work done.
• A business relationship exists between a member of the engagement team and client
personnel.
• Reduce the member’s responsibilities on the team.
• Reduce the magnitude of the business relationship.
19-10 Loans from banks and similar institutions to a member of the assurance team or their
immediate family made under normal commercial terms are acceptable under certain
conditions. This includes home mortgages, bank overdrafts, car loans and credit card balances
under normal lending terms. Only immaterial loans are acceptable if the provider of the loan is
not a bank or similar institution.
19-11 Providing valuation services to the audit client may be acceptable if the valuation
services are neither separately, nor in the aggregate, material to the financial statements, or that
do not involve a significant degree of subjectivity.
Applicable safeguards are:
• Involving an additional professional accountant who was not a member of the audit
team to review the work done or otherwise advise as necessary.
• Confirming with the audit client their understanding of the underlying assumptions of
the valuation and the methodology to be used and obtaining approval for their use.
• Obtaining the audit client’s acknowledgement of responsibility for the results of the
work performed by the firm.
• Making arrangements so that personnel providing such services do not participate in
the audit engagement.
19-12 Acceptable corporate finance services to an audit client are:
• Assisting the client in developing corporate strategies.
• Assisting an audit client in identifying or introducing the client to possible sources of
capital that meet the client specifications or criteria.
• Providing structuring advice and assisting the client in analyzing the accounting
effects of proposed transactions.
Safeguards include implementing policies and procedures to prohibit individuals assisting the
client from making managerial decisions on behalf of the client, and using professionals who are
not members of the assurance team to provide the services,.
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19-13 The purpose of establishing a system of quality control is to monitor the firms’ practices
and ensure that professional standards are being followed.
Elements of the quality control system and related policy or procedures are:
• Leadership responsibilities for quality within the firm.
• The firm’s chief executive officer assumes ultimate responsibility for the firm’s
system of quality control.
• Management responsibilities are assigned so that commercial considerations do
not override the quality of work performed.
• Ethical requirements.
• Ethical requirements relating to audits and reviews of historical financial
information, and other assurance and related services engagements comprise
Parts A and B of the IFAC Code together with national requirements that are
more restrictive.
• The firm’s policies and procedures emphasize the fundamental principles, which
are reinforced in particular by a) the leadership of the firm, b) education and
training, c) monitoring, and d) a process for dealing with non-compliance.
• Acceptance and continuance of client relationships and specific engagements.
• Consider the identity and business reputation of the client’s principal owners, key
management, related parties, and those charged with its governance.
• On withdrawal from an engagement document significant issues, consultations,
conclusions, and the basis for the conclusions.
• Human resources.
• The advancement to positions of greater responsibility within the firm depends,
among other things, upon performance quality and adherence to ethical
principles.
• The firm provides the necessary training resources and assistance to enable
personnel to develop and maintain the required capabilities and competence.
• Engagement performance.
• Supervision of engagements includes identifying matters for consultation or
consideration by more experienced engagement team members during the
engagement.
• All audits of financial statements of listed entities require an engagement quality
control review.
• Monitoring.
• The firm communicates to relevant engagement partners and other appropriate
personnel deficiencies noted as a result of the monitoring process and
recommendations for appropriate remedial action.
• At least annually, the firm communicates the results of the monitoring of its
quality control system to engagement partners and other appropriate individuals
within the firm, including the firm’s chief executive officer.
19-14 Variety exists among countries in the structure of quality assurance programmes for
inspecting and reviewing audit firms’ practices. IFAC SMO 1 and EU minimum requirements,
however, foster a more common structure. An effective quality assurance programmes should
be transparent. Thus, most programmes will inform about their structure and report to the public
outcomes of reviews and sanctions imposed. You could search for information on the quality
assurance programmes in the relevant country by approaching the relevant national
accountancy body or regulatory body. (See also Internet Assignment 19-24.)
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Solutions to Problems
19-15 Wareham may identify the following areas as being potential avenues for non-assurance
services.
•
Developing an automated accounting system.
•
Providing tax-planning advice.
•
Provision of the internal audit services.
•
Developing projections and/or forecasts for the company’s new products.
The audit firm should not assume management accounting system functions and make
management decisions. The Code implies that the firm can only be involved in the design and
implementations of an automated accounting system if some specific conditions are met (see
page 609). If the service from the firm involves either the design or the implementation of an
accounting system, appropriate safeguards should be applied.
Generally, provision of tax-planning advice is allowed by IFAC independence rules.
Consideration should, however, be given to whether the provision of such advices would create
a threat to independence.
The firm should not assume audit client responsibility for internal audit activities and
management decisions. Independence may not be impaired if the service (1) is an extension of
the firm’s audit service conducted in accordance with the ISAs or (2) assistance in the
performance of an audit client’s internal audit activities or undertaking the outsourcing of some
of the activities, given certain specific conditions are met (see pages 608-609).
Assisting the client to develop projections and/or forecasts for the company’s new
products and other non-assurance work would be strictly limited by the principles of not
performing a management function, not auditing one’s own work, and not performing an
advocacy role.
Consideration should also be given to whether the non-assurance services should be
provided only by personnel not involved in the audit engagement and with different reporting
lines within the firm.
Because the client is a listed company, regular communications between the firm and
the audit committee or other governance body regarding independence issues related to the
provision of the non-assurance services should take place.
19-16 The auditor and audit firm should in all situations apply the threat and safeguard
approach inherent in the conceptual framework. The auditor should also adhere to guidance
and comply with the specific provisions in the IFAC Code of Ethics.
a. No. The IFAC Code allows an auditor to provide such advisory services to an audit
client. Independence would be not considered impaired because the auditor’s role is
advisory in nature. The auditor should, however, take care not to assume audit client
responsibility or make management decisions.
b. No. The auditor’s independence is not impaired under these circumstances provided
the client makes all significant management decisions related to the hiring of new
personnel and the design and implementation of the system. For example, the
auditor can review the professional qualifications of the applicants and provide
advice on their suitability. The auditor should limit his or her supervisory activities to
initial instruction and training of personnel and avoid direct supervision of the actual
operation of the system or related activities that would constitute undue involvement
in with management functions.
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c. Yes. A close business relationship between the auditor and the audit client may
cause self-interest or intimidation threats. The Code states that auditor would not be
independent unless the common financial interest is immaterial and the relationship
is clearly insignificant to the client and/or the auditor. No safeguards would reduce
the threats created by the joint purchase of the auditor and client to an acceptable
level.
d. Yes. The Code states that the auditor should not have a direct financial interest or a
material indirect financial interest in the audit client. Shares in a blind trust would be
considered an indirect financial interest. (In a blind trust a fiduciary third party has
complete management discretion.) Thus, the independence of the auditor would be
considered impaired whether or not the financial interest is placed in a blind trust.
e. Yes. Interpretation of the Code indicates that an auditor’s independence would be
considered impaired if a close relative (e.g. a parent) has a direct financial interest in
an enterprise of which the auditor is participating in the engagement.
f.
Yes. Independence under the Code is impaired because a member has a direct
financial interest in a client during the period of the audit engagement. For recurring
engagement the period of the engagement ends with the notification by either party
that the professional relationship has terminated or the issuance of the final audit
report, whichever is later.
g. Yes. Independence under the Code is impaired because the note for unpaid fees
might be regarded as equivalent to a loan prohibited from the member to the client.
19-17 a.
b.
c.
d.
Yes
No
Yes
Yes
19-18 a. Yes. Signing such a letter would be a known misrepresentation of fact in violation of
the Code’s principle of professional behaviour as well as the principle of professional
competence and due care.
b. Yes. This would be a violation of the Code because McDermott’s employer is the
source of the revenues for the entities being audited.
c. Yes. If a member in industry uses confidential information obtained from an
employer for his or her personal benefit, disclosure of the information is considered
an act discreditable to the principle of confidentiality.
d. No. This is an example of conflict in the application of fundamental principles;
integrity/professional behaviour and confidentiality. Interpretation of the principles
and the Code’s guidance on resolution of conflicts between principles indicate that
the professional accountant in business should communicate the problem to third
parties, such as regulators. However, the accountant should consult his lawyer prior
to any disclosure.
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e. Yes. The accountant’s negligence makes or permits another to make false and
misleading entries in the financial statements. This would be a violation of the
principles of professional behaviour and competence and due care.
19-19 a. Services that Savage may perform:
• Counsel on potential expansion plans.
• Search for and interview new personnel.
• Train personnel.
Services that Savage may not perform:
• Hire new personnel.
• Supervise the operation of the system.
• Monitor client-prepared source documents and make changes in basic ITgenerated data without the concurrence of the client.
b. The significant matters related to an engagement generally include (a) the
engagement’s objectives, (b) the scope, (c) the approach, (d) the role of all
personnel, (e) the manner in which results are to be communicated, (f) the timetable,
and (g) the fee.
c. Savage must be qualified to supervise and evaluate the work of specialist
employees. Although supervision does not require that Savage be qualified to
perform each of the specialists’ tasks, Savage should be able to define the tasks and
evaluate the end product.
Solutions to Discussion Cases
19-20 a. If Pina, Johnson & Associates audited one of the entities that received one of the
large loans, it would not be appropriate for Johnson to seek financial information
about that entity from the other auditors in his firm. The other auditor shall not
disclose any confidential client information without the specific consent of the client.
b. If Johnson had obtained the information about the possible violations of
environmental laws from appropriate sources, it would not be unethical to use such
information in determining the fair value of the loan owed to Sun City Bank. The
auditor has an obligation to use such information in assessing the entity’s ability to
repay the loan.
19-21 Kmart has physical assets and trades in physical goods, but Arthur Andersen’s primary
asset was a reputation for competence, professionalism, and integrity. While Kmart could file
for bankruptcy and reorganize its business, Andersen’s loss of reputation, its most important
operating asset, could not be repaired, resulting in the loss of its clients. Andersen’s fate was
essentially sealed long before the firm was convicted on obstruction of justice charges. Their
reputation was damaged prior to the Enron scandal by a string of questionable practices and
audit failures (involving Sunbeam, Waste Management, The Baptist Foundation of Arizona, and
others) and was finished off by the Enron scandal and indictment.
19-22 a. No IFAC member body or firm is allowed to apply less stringent standards than those
stated in the Code unless prohibited by law or regulation. Part A of the IFAC Code of
Ethics applies to all professional accountants who are members of an IFAC body.
Part B of the Code applies to professional accountants in public practice, while Part
C applies to professional accountants in business.
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b. This, of course, is a judgment question. Some practitioners believe that the Code of
Ethics should be applied the same to all professional accountants, while other do
not. IFAC has settled on a between position; a part of the Code applies to all
professional accountants, while other parts are directed towards those in public
practice and business, respectively.
19-23 The auditor and audit firm should in all situations apply the threat and safeguard
approach inherent in the conceptual framework. The auditor should also adhere to guidance
and comply with the specific provisions in the IFAC Code of Ethics. For listed entities the Code
prescribes that there should be regular communications between the firm and the audit
committee (or other governance body if there is no audit committee) regarding relationships and
other matters that might, in the firm’s opinion, reasonably be thought to bear on independence.
a. This is situation where a member of the audit team of the firm has joined the audit
client. The Code advices on factors affecting the significance of the threats and
relevant applicable safeguards in this situation. No independence provisions of the
Code are violated unless (1) Adrian is entitled to any benefits or payments from the
firm other than those made in accordance with fixed pre-determined arrangements,
(2) any amount owed to Adrian is not be of such significance to threaten the firm’s
independence and (3) Adrian does not continue to participate or appear to
participate in the firm’s business or professional activities.
b. Generally the firm cannot continue an engagement if a former engagement partner of
an audit client that is a listed entity had joined the client before an audited financial
statement, for which another engagement partner was responsible, had been filed.
This provision of the Code does not apply in Susana’s situation, i.e. independence is
not impaired.
c. As long as Janay is not providing the appraisal service for the client, but only as part
of the audit to verify the valuation assertion, no violation has been committed. If the
appraisal service were performed on behalf of the client, and not strictly for the
purposes of verifying the client’s estimates for audit purposes, then this would violate
the Code’s independence standards.
d. This situation is not discussed in the Code. A self-review threat is present if Greg
audits his own work in regards to the subsidiary when participating in the audit for the
parent company.
e. A self-interest threat is created when the total fees generated by an audit client
represent a large proportion of a firm’s total fees or of the revenue of an individual
partner. Compensating an audit partner on an audit team for selling non-assurance
services to the audit client may also create a self-interest threat. The Code advices
on factors affecting the significance of the threats and possible safeguards in these
situations. No violation of the Code exists as long as all of the services are
performed in accordance with the Code’s independence rules and safeguards are
applied to bring any self-interest threats to an acceptable level.
Internet Assignment
19-24 An effective quality assurance programme should be transparent. Thus, information
about the structure of the programmes will normally be accessible; typically on a website of the
body that does the quality control inspections. (Refer to Review Question 19-14.)
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CHAPTER 20
ASSURANCE, RELATED SERVICES AND INTERNAL AUDITING SERVICES
Answers to Review Questions
20-1 The Elliott Committee defines assurance services as independent professional services
that improve the quality of information, or its context, for decision makers. The definition
focuses on decision-making because good decision-making requires quality information that can
be financial or non-financial. An assurance service engagement can aid the decision maker in
searching through the available information in order to identify which pieces of information are
relevant for the required decision and in improving the quality of the information or its context.
An assurance service engagement can also improve quality through increasing confidence in
the information’s reliability and relevance.
20-2 IAASB engagement standards are either within the scope of the IAASB framework for
assurance engagements or are related services standards (ISRSs). Assurance standards are
International Standards on Auditing (ISAs), International Standards on Review Engagements
(ISREs) or International Standards on Assurance Engagements (ISAEs). ISAs are applied to
audits of historical financial information such as a financial statement audit. ISREs are applied
to reviews of historical financial information such as a review of interim financial statements.
ISAEs are applied in assurance engagements dealing with subject matters and subject matters
information other than historical financial information such as assurance of prospective financial
information and sustainability information.
Related services are not considered assurance services. ISRSs are applied to
compilation engagements and engagements to apply agreed upon procedures to information.
In a compilation engagement the auditor is presenting, ordinarily in the form of financial
statements, information that is the representation of management without undertaking to
express any assurance on the information. An agreed-upon procedures engagement is one in
which a auditor is engaged by a client to issue a report of findings based on specific procedures
performed on financial information, i.e. without expressing any assurance.
20-3 An assurance engagement means an engagement in which a practitioner expresses a
conclusion designed to enhance the degree of confidence of the intended users other than the
responsible party about the outcome of the evaluation or measurement of a subject matter
against criteria.
A practitioner refers to a professional accountant in public practice. The intended users
are persons for whom the practitioner prepares the assurance report. The responsible party is
the person responsible for the subject matter (or subject matter information). The subject
matter is the underlying phenomenon that is measured or evaluated. (The subject matter
information means the outcome of the evaluation or measurement of a subject matter.) Criteria
are the benchmarks used to evaluate or measure the subject matter.
A subject matter is appropriate if (1) it is identifiable and capable of consistent evaluation
or measurement against the identified criteria, and (2) can be subjected to procedures for
gathering sufficient appropriate evidence to support a reasonable assurance or limited
assurance conclusion. To be suitable criteria have to be relevant, complete, reliable, neutral
and understandable.
20-4 The assurance levels of IAASB assurance engagement standards are either reasonable
assurance or limited assurance. Reasonable assurance means that the engagement assurance
risk is reduced to an acceptably low level in the circumstances of the engagement. In a limited
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assurance engagement the risk is greater than for a reasonable assurance engagement, but still
acceptable in the circumstances of the engagement. The practitioner reduces assurance
engagement risk by gathering evidence. The nature, timing and extent of procedures for
gathering sufficient appropriate evidence in a limited assurance engagement are deliberately
limited relative to a reasonable assurance engagement, but at least sufficient for the practitioner
to obtain a meaningful level of limited assurance.
A reasonable assurance engagement report includes a positive form of expression of the
conclusion, e.g. in an unmodified conclusion on a subject matter the practitioner states that in
his or her opinion the responsible party’s assertion about the subject matter is, in all material
respects, based on the criteria. In a limited assurance engagement, the practitioner expresses
the conclusion in a negative form, e.g. in an unmodified conclusion on a subject matter the
practitioner states that based on his or her work nothing has come to the attention that causes
the practitioner to believe that the responsible party’s assertion about the subject matter is not,
in all material respects, based on the criteria.
20-5 Entities that are not required to have their financial statements audited, may request a
review report of the financial statements. In other situations the practitioner, ordinarily the
auditor of the entity, may be asked to review the entity’s interim financial information.
The assurance level in a review report is expressed in the negative form, e.g. ‘Based on
our review, nothing has come to our attention that causes us to believe that the accompanying
financial information does not present fairly, in all material respects, the financial position of the
entity ….’.
20-6 An audit of financial statements is an assurance engagement and financial statements
are historical financial information. Historical financial information is to one of several types of
subject matter information. This explains why the nature of the basic principles, essential
procedures and report in an assurance engagement where the subject matter information is not
historical financial information does not differ fundamentally from those in an audit.
The practitioner should be involved in the engagement and understand the work of the
expert to an extent that is sufficient to enable the practitioner to accept responsibility for the
conclusion on the subject matter information. The practitioner should also obtain sufficient
appropriate evidence that the expert’s work is adequate for the purposes of the assurance
engagement.
20-7 ISAE 3000 is an ‘umbrella’ standard for assurance engagement other than audits or
reviews of historical financial information. The standard provides basic principles and essential
procedures that could be used for on a broad range of assurance services. This includes
assurance services related financial performance (e.g. historical or prospective financial
information), non-financial performance (e.g. key performance indicators of efficiency and
effectiveness, or sustainability reporting), systems and processes (e.g. internal control) and
behaviour (e.g. compliance with laws and regulations).
20-8 Sustainability reporting includes information on companies’ environmental, social and
economic performance. Stakeholders need information on the environmental, social and
economic impact of companies’ activities that is reliable.
20-9 Prospective financial information is either financial forecasts or financial projections.
Financial forecasts are prospective financial information that presents an entity’s expectation on
the information (e.g. expected financial position, results of operations and cash flows). They are
based on assumptions reflecting conditions the responsible party expects to exist and the
course of action it expects to take. Financial projections are prospective financial information
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based on one or more hypothetical assumptions about future events and the responsible party’s
actions. These assumptions may not reflect the most likely or expected conditions.
The primary difference between the two is that the financial projection is based on
hypothetical assumptions and is intended to respond to a question such as ‘What would happen
if...?’ A financial projection is sometimes prepared to present one or more hypothetical courses
of action for evaluation. Financial forecasts are expectations. Additionally, financial projections
can be used only for limited distribution to specified parties, while forecasts can also be
generally distributed.
20-10 There are three broad categories of risks associated with electronic commerce:
business practices, transaction integrity and information protection.
Trust Services are built on five principles:
• Security: The system is protected against unauthorized access (both physical and
logical).
• Availability: The system is available for operation and use as committed or agreed.
• Processing Integrity: System processing is complete, accurate, timely and
authorized.
• Online Privacy: Personal information obtained as a result of e-commerce is
collected, used, disclosed, and retained as committed or agreed.
• Confidentiality: Information designated as confidential is protected as committed or
agreed.
20-11 In an agreed-upon procedures engagement no assurance is expressed since the
practitioner simply provides a report of factual findings based on the agreed procedures
performed on financial information.
20-12 In a compilation engagement the practitioner uses his or her accounting expertise, as
opposed to auditing expertise, to collect, classify, and summarize financial information.
The practitioner should obtain the following knowledge about the entity:
• General knowledge of the business and operations of the entity.
• Be familiar with the accounting principles and practices of the industry in which the
entity operates.
• Be familiar with the form and content of the financial information that is appropriate in
the circumstances.
20-13 An organization’s internal audit function is used by management and the board of
directors in the broad areas of evaluating risks, evaluating compliance, and performing financial
and operational auditing. The internal auditing function can help management and the board
identify and manage risk, and help ensure the compliance of the organization with applicable
laws, rules, and regulations. In addition, if reporting responsibilities are properly defined, the
internal audit function can assist the board in ensuring that executive management is exercising
responsible and appropriate stewardship over the entity’s resources for the benefit of the entity’s
stakeholders.
Solutions to Problems
20-14 a. A review consists primarily of applying analytical procedures and making inquiries of
members of management responsible for financial and accounting matters.
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b. Independent Report on Review of Interim Balance Sheet To the Shareholders of the
Ajax Company
Introduction
We have reviewed the accompanying balance sheet of Ajax Company of 30 June,
2005 and a summary of significant accounting policies and other explanatory notes.
Management is responsible for the preparation and presentation and of this interim
balance sheet in accordance with International Financial Reporting Standards. Our
responsibility is to express a conclusion on this interim balance sheet based on our
review.
Scope of Review
We conducted our review in accordance with International Standard on Review
Engagements 2410, Review of Interim Financial Information Performed by the
Independent Auditor of the Entity. A review of interim financial information consists
of making inquiries of persons responsible for financial and accounting matters and
applying analytical and other review procedures. A review is substantially less in
scope than an audit conducted in accordance with International Standards on
Auditing and consequently does not enable us to obtain assurance that we would
become aware of all significant matters that might be identified in an audit.
Accordingly, we do not express an audit opinion.
Conclusion
Based on our review, nothing has come to our attention that causes us to believe
that the accompanying interim balance sheet does not present fairly, in all material
respects, the financial position of the entity as at 30 June 2005 in accordance with
International Financial Reporting Standards.
Fleisher & Schmidt, date and address
20-15 a. Independent Assurance Report To the Shareholders of Eastern Star Bank
We have provided assurance on management’s assertion included in the
accompanying management report on internal control, that Eastern Star Bank (ESB)
maintained effective internal control over financial reporting as of 31 December 2005
in accordance with control criteria included in the COSO internal control framework.
ESB’s management is responsible for maintaining effective internal control over
financial reporting. Our responsibility is to express a conclusion about ESB’s
assertion.
This engagement was conducted in accordance with the International Standard
for Assurance Engagement 3000 Assurance Engagements Other Than Audits or
Reviews of Historical Financial Information, and, accordingly, included obtaining an
understanding of the internal control over financial reporting, testing and evaluating
the design and operating effectiveness of internal control, and performing such other
procedures as we considered necessary in the circumstances. We believe that our
assurance provides a reasonable basis for our conclusion.
Because of inherent limitations in any internal control, misstatements due to
errors or fraud may occur and not be detected. Also, projections of any evaluation of
the internal control over financial reporting to future periods are subject to the risk
that internal control may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate.
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In our opinion, EBS maintained effective internal control over financial reporting
as of 31 December 2005, in all material respects, based on control criteria included
in the COSO internal control framework.
Auditor, date and address
b. [Standard introductory, scope, and inherent limitations paragraphs.]
As discussed in management’s assertion, the following material weakness exists
in the design or operation of the internal control system of EBS in effect at 31
December 2005: EBS does not have adequate loan procedures for ensuring the
adequacy of collateral for loans. This results in EBS failing to meet the control
criteria for proper valuation. A material weakness is a condition that precludes the
entity’s internal control system from providing reasonable assurance that material
misstatements will be prevented or detected on a timely basis.
In our opinion, except for the effect of the material weakness described in the
preceding paragraph on the achievement of the objectives of the control criteria, EBS
maintained effective internal control over financial reporting as of 31 December,
2005, in all material respects, based on control criteria included in the COSO internal
control framework.
Auditor, date and address
20-16 a. Consumers are reluctant to engage in electronic commerce for several reasons.
First, consumers want to know that the entity behind the Web page is ‘real’. In other
words, how can the consumer be sure that the entity follows good business practices
and that they will not be defrauded? Second, consumers are worried that electronic
transactions will be changed, lost, duplicated, or processed incorrectly. Lastly, the
consumer is concerned that private information will be stolen.
b. Your firm can provide assurances about Rhett Corporation’s security, availability,
processing integrity, online privacy, and confidentiality by completing a WebTrust
engagement.
c. The process for providing WebTrust assurance is as follows: Rhett Corporation
would have to meet all of the Trust Services Principles as measured by the relevant
criteria. Your firm would conduct an assurance engagement using guidance
provided by ISAE 3000 Assurance Engagements Other Than Audits or Reviews of
Historical Financial Information. Four steps would be taken to complete the
examination of management’s assertions:
• Obtain an understanding of Rhett Corporation’s electronic commerce business
practices and its controls over the processing of electronic commerce
transactions and the protection of related private customer information.
• Selectively test transactions executed in accordance with the disclosed practices.
• Test and evaluate the operating effectiveness of the controls.
• Perform other procedures that are considered necessary.
Once the WebTrust seal is obtained, it is displayed on Rhett Corporation’s web site.
The seal is managed by a third party service organization.
20-17 a. If the practitioner becomes aware of material misstatements in Cheaney Rental
Properties income statements, the practitioner should try to agree appropriate
amendments with the entity. If such amendments are not made and the financial
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information is considered to be misleading, the practitioner should withdraw from the
engagement.
b. Independent Accountant’s Compilation Report To the Board of Directors of Cheaney
Rental Properties
On the basis of information provided by management we have compiled, in
accordance with the International Standard on Related Services applicable to
compilation engagements, the income statement of Cheaney Rental Properties for
the year 200X. Management is responsible for these financial statements. We have
not audited or reviewed the income statement and accordingly express no assurance
thereon.
Auditor, date and address
Solution to Discussion Case
20-18 a. A practitioner may perform reasonable assurance or limited assurance engagement
to evaluate an entity’s written assertion that it was in compliance with environmental
laws and regulations, as well as compliance with company policies and procedures.
In a limited assurance engagement sufficient appropriate evidence is obtained as
part of a systematic engagement process that includes obtaining an understanding of
the subject matter and other engagement circumstances, but in which procedures
are deliberately limited relative to a reasonable assurance engagement (typically
analytical procedures and inquiries of management). Further, the use of the
assurance report (whether expressing reasonable or limited assurance) may be
restricted to specified users.
The practitioner and the client must first agree on the assurance level of the
engagement and on any restriction on the use of the assurance report. Before
accepting the engagement the practitioner should in addition ascertain that:
• Relevant ethical requirements, including independence and professional
competence are satisfied.
• The responsible party will provide the compliance assertion in writing to the
practitioner.
• The compliance assertion is capable of consistent evaluation or measurement
against the identified criteria, and can be subjected to procedures for gathering
sufficient appropriate evidence to support an assurance conclusion.
• The environmental laws and regulations as well company policies and
procedures are suitable as criteria.
• The procedures to be applied to the compliance assertion are expected to result
in reasonably consistent findings using the criteria.
• The practitioner has access to sufficient appropriate evidence to support the
practitioner’s conclusion.
The practitioner should plan and perform an assurance engagement to obtain
sufficient appropriate evidence about whether the entity’s written assertion was in
compliance with environmental laws and regulations, as well as compliance with
company policies and procedures. In a reasonable assurance engagement sufficient
appropriate evidence is obtained as part of a systematic engagement process that
includes:
• Obtaining an understanding of the specified compliance requirements by
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•
•
•
•
considering the following:
• Laws, regulations, rules, contracts and grants that pertain to the specified
compliance requirements, including published requirements.
• Knowledge about the specified compliance requirements obtained through
prior engagements and regulatory reports.
• Knowledge about the specified compliance requirements obtained through
discussions with appropriate individuals within the entity (e.g. the chief
financial officer, internal auditors, legal counsel, compliance officer, or grant
or contract administrators).
• Knowledge about the specified compliance requirements obtained through
discussions with appropriate individuals outside the entity (e.g. a regulator or
third-party specialist).
Based on that understanding, assessing the risks that the subject matter
information may be materially misstated.
Responding to assessed risks, including developing overall responses and
determining the nature, timing, and extent of further procedures.
Performing further procedures clearly linked to the identified risks, using a
combination of inspection, observation, confirmation, recalculation, reperformance, analytical procedures and inquiry. Such further procedures involve
substantive procedures, including, where applicable, obtaining corroborating
information, and if reliance of internal controls are planned, tests of the operating
effectiveness of controls. (See also b. below.)
Evaluating the sufficiency and appropriateness of evidence obtained.
b. If the entity maintained an internal control system which monitored the entity’s
compliance with environmental laws and regulations, the practitioner would evaluate
the effectiveness of the system as follows:
• By obtaining an understanding of the relevant portions of the internal control
system over compliance sufficient to plan the engagement and to assess control
risk for compliance with specified requirements.
• By obtaining an understanding of the design of specific internal controls by
performing inquiries of appropriate management, supervisory, and staff
personnel; inspection of the entity’s documents; and observation of the entity’s
activities and operations.
• If control risk is to be assessed below the maximum, by performing tests of
controls to support the assessed level of control risk.
Solution to Internet Problems
20-19 a. On its home page Global Reporting Initiative (GRI) informs on organisational
stakeholders that use the GRI Guidelines. A number of these stakeholders are
companies that also have their sustainability reporting assured, including BP, Philips
and Statoil. (These three companies 2004 assurance reports are discussed in the
following.)
b. Ernst & Young assures the sustainability reports of BP and Statoil, while KPMG
assures the sustainability report of Philips.
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c. Ernst & Young assures the sustainability report of BP against AccountAbility’s
AA1000 Assurance Standard. Ernst & Young and KMPG use IAASB ISAE 3000 in
their assurance of the sustainability reports of Statoil and Philips.
d. The basic elements of an assurance report as required by ISAE 3000 are listed on
page 641. Comparing the content of the assurance reports of Ernst & Young
(Statoil) and KMPG (Philips) reveals that the reports generally include the basic
elements of reporting according to ISAE 3000.
In the title of its assurance report neither KPMG nor Ernst & Young include the
phrase ‘independence’. Independence is, however, discussed in the preface to
KPMG’s assurance report (‘Auditor policy’) and the IFAC Code of Ethics for
Professional Accounts is referred to in their report. Ernst & Young refers to
independence in the scope paragraph of their assurance report.
20-20 a. Timberland, Lands’ End and L. L. Bean all sell products over the Internet, but we
could not identify any form of third-party assurance on the companies’ Web sites as
of December 2005. As of 2005, Lands’ End uses Secure Socket Layers (SSL) and
L. L. Bean uses the VeriSign SSL Certificate to secure customers’ private
information. SSL is a standard encryption protocol used on the Internet to provide a
secure connection. VeriSign Inc. operates the VeriSign SSL Certificate services that
enable and protect interactions across data networks.
b. The VeriSign seal is different from WebTrust. When a user clicks on the VeriSign
seal they are referred to a validation page that confirms that the entity is a licensee of
the VeriSign privacy program. The VeriSign seal (and use of SSL) does not provide
any assurances similar to those provided by WebTrust. It should be noted that
Timberland, L. L. Bean, and Land’s End all provide very detailed information on
security and privacy issues.
20-21 a. From the home page, click on the ‘Publications’ link. This page identifies Internal
Auditor as the official magazine of the IIA. Following the ‘Internal Auditor’ link takes
you to a page with a ‘mission’ link. The mission is stated as follows: ‘Our mission is
to share information and practices and provide news analysis and commentary that
internal audit practitioners and other interested professionals from around the world
need to do their jobs in the modern organization.’
b.
From the home page, click on the ‘Certification’ link. This page details the following
five advantages of the CIA certification:
• Distinguishes you from your peers.
• Carries weight with internal staff and external clients.
• Demonstrates your proficiency and commitment to professionalism.
• Gives you personal satisfaction of achievement.
• Lays a foundation for continued career improvement and advancement.
On the same page is a link to ‘Certified Internal Auditor.’ This link provides
information on the exam and suggests the following groups would benefit from the
designation:
• Chief audit executives.
• Audit managers and audit staff.
• Educators and students.
• Managers who need to update their business knowledge to craft successful
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•
•
business strategies.
Anyone who is responsible for making corporate decisions.
Anyone who wants to create economic value for themselves and their
organization.
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