Solutions to Review Questions ACCT 425

8/9/2019 Solutions to Review Questions ACCT 425

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Chapter 1 - The Demand for Audit and Other Assurance Services

1-1 The relationship among audit services, attestation services, and assurance services isreflected in Figure 1-3 on page 13 of the text. An assurance service is an independentprofessional service to improve the quality of information for decision makers. An attestationservice is a form of assurance service in hich the !"A firm issues a report a#out the relia#ilityof an assertion that is the responsi#ility of another party. Audit services are a form of attestationservice in hich the auditor expresses a ritten conclusion a#out the degree of correspondence#eteen information and esta#lished criteria.

The most common form of audit service is an audit of historical financial statements, inhich the auditor expresses a conclusion as to hether the financial statements are presentedin conformity ith generally accepted accounting principles. An example of an attestationservice is a report on the effectiveness of an entity$s internal control over financial reporting.There are many possi#le forms of assurance services, including services related to #usinessperformance measurement, health care performance, and information system relia#ility.

1-2 An independent audit is a means of satisfying the need for relia#le information on thepart of decision makers. Factors of a complex society hich contri#ute to this need are%

1. &emoteness of informationa. 'ners (stockholders) divorced from management#. *irectors not involved in day-to-day operations or decisionsc. *ispersion of the #usiness among numerous geographic locations and

complex corporate structures+. iases and motives of provider

a. nformation ill #e #iased in favor of the provider hen his or her goalsare inconsistent ith the decision makers goals.

3. /oluminous dataa. "ossi#ly millions of transactions processed daily via sophisticated

computeri0ed systems

#. ultiple product linesc. ultiple transaction locations

2. !omplex exchange transactionsa. e and changing #usiness relationships lead to innovative accounting

and reporting pro#lems#. "otential impact of transactions not quantifia#le, leading to increased

disclosures

1-3 1. Risk-free interest rate This is approximately the rate the #ank could earn #yinvesting in 4.5. treasury notes for the same length of time as the #usiness loan.

+. Business risk for the customer This risk reflects the possi#ility that the #usiness illnot #e a#le to repay its loan #ecause of economic or #usiness conditions such as

a recession, poor management decisions, or unexpected competition in theindustry.

3. Information risk This risk reflects the possi#ility that the information upon hich the#usiness risk decision as made as inaccurate. A likely cause of theinformation risk is the possi#ility of inaccurate financial statements.

Auditing has no effect on either the risk-free interest rate or #usiness risk. 6oever,auditing can significantly reduce information risk.

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1-4 The four primary causes of information risk are remoteness of information, #iases andmotives of the provider, voluminous data, and the existence of complex exchange transactions.

The three main ays to reduce information risk are%

1. 4ser verifies the information.

+. 4ser shares the information risk ith management.3. Audited financial statements are provided.

The advantages and disadvantages of each are as follos%

ADVANTAGS D!SADVANTAGS

"S# V#!$!S!N$O#%AT!ON

1. 4ser o#tains informationdesired.

+. 4ser can #e more confidentof the qualifications andactivities of the person gettingthe information.

1. 6igh cost of o#taininginformation.

+. nconvenience to theperson providing theinformation #ecauselarge num#er of usersould #e on premises.

"S# S&A#S!N$O#%AT!ON#!S' (!T&%ANAG%NT

1. o audit costs incurred. 1. 4ser may not #e a#le tocollect on losses.

A"D!TD$!NANC!A)STAT%NTSA# *#OV!DD

1. ultiple users o#tain theinformation.

+. nformation risk can usually#e reduced sufficiently tosatisfy users at reasona#lecost.

3. inimal inconvenience tomanagement #y having onlyone auditor.

1. ay not meet needs ofcertain users.

+. !ost may #e higherthan the #enefits insome situations, suchas for a small company.

1-+ To do an audit, there must #e information in a verifiable form and some standards(criteria) #y hich the auditor can evaluate the information. 7xamples of esta#lished criteriainclude generally accepted accounting principles and the nternal &evenue !ode. *eterminingthe degree of correspondence #eteen information and esta#lished criteria is determininghether a given set of information is in accordance ith the esta#lished criteria. The informationfor 8ones !ompanys tax return is the federal tax returns filed #y the company. The esta#lished

criteria are found in the nternal &evenue !ode and all interpretations. For the audit of 8ones!ompanys financial statements the information is the financial statements #eing audited andthe esta#lished criteria are generally accepted accounting principles.

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1-, The primary evidence the internal revenue agent ill use in the audit of the 8ones!ompanys tax return include all availa#le documentation and other information availa#le in8ones office or from other sources. For example, hen the internal revenue agent auditstaxa#le income, a ma9or source of information ill #e #ank statements, the cash receipts 9ournaland deposit slips. The internal revenue agent is likely to emphasi0e unrecorded receipts andrevenues. For expenses, ma9or sources of evidence are likely to #e cancelled checks, vendors

invoices and other supporting documentation.

1- This apparent paradox arises from the distinction #eteen the function of auditing andthe function of accounting. The accounting function is the recording, classifying andsummari0ing of economic events to provide relevant information to decision makers. The rulesof accounting are the criteria used #y the auditor for evaluating the presentation of economicevents for financial statements and he or she must therefore have an understanding of generallyaccepted accounting principles (:AA"), as ell as auditing standards. The accountant neednot, and frequently does not, understand hat auditors do, unless he or she is involved in doingaudits, or has #een trained as an auditor.

1-.

O*#AT!ONA)A"D!TS

CO%*)!ANCA"D!TS

A"D!TS O$$!NANC!A)STAT%NTS

*"#*OS To evaluatehether operatingprocedures areefficient andeffective

To determine hetherthe client is folloingspecific procedures set#y higher authority

To determinehether the overallfinancialstatements arepresented inaccordance ithspecified criteria

(usually :AA")"S#S O$A"D!T#*O#T

anagement of organi0ation

Authority setting donprocedures, internal or external

*ifferent groups for different purposes; many outsideentities

NAT"# 6ighlynonstandard< oftensu#9ective

ot standardi0ed, #utspecific and usuallyo#9ective

6ighlystandardi0ed

PERFORMEDBY:

C*As Frequently 'ccasionally Almost universallyGAOA"D!TO#S Frequently Frequently 'ccasionally!#SA"D!TO#S ever 4niversally ever !NT#NA)A"D!TO#S Frequently Frequently Frequently

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1-/ Five examples of specific operational audits that could #e conducted #y an internalauditor in a manufacturing company are%

1. 7xamine employee time cards and personnel records to determine if sufficientinformation is availa#le to maximi0e the effective use of personnel.

+. &evie the processing of sales invoices to determine if it could #e done more

efficiently.3. &evie the acquisitions of goods, including costs, to determine if they are #eing

purchased at the loest possi#le cost considering the quality needed.2. &evie and evaluate the efficiency of the manufacturing process.=. &evie the processing of cash receipts to determine if they are deposited as quickly

as possi#le.

1-10 >hen using a strategic systems auditing approach in an audit of historical financialstatements, an auditor must have a thorough understanding of the client and its environment.This knoledge should include the client$s regulatory and operating environment, #usinessstrategies and processes, and measurement indicators. The strategic systems approach is alsouseful in other assurance or consulting engagements. For example, an auditor ho is

performing an assurance service on information technology ould need to understand theclient$s #usiness strategies and processes related to information technology, including suchthings as purchases and sales via the nternet. 5imilarly, a practitioner performing a consultingengagement to evaluate the efficiency and effectiveness of a client$s manufacturing processould likely start ith an analysis of various measurement indicators, including ratio analysisand #enchmarking against key competitors.

1-11 The ma9or differences in the scope of audit responsi#ilities are%

1. !"As perform audits in accordance ith auditing standards of pu#lished financialstatements prepared in accordance ith generally accepted accountingprinciples.

+. :A' auditors perform compliance or operational audits in order to assure the!ongress of the expenditure of pu#lic funds in accordance ith its directives andthe la.

3. &5 agents perform compliance audits to enforce the federal tax las as defined #y!ongress, interpreted #y the courts, and regulated #y the &5.

2. nternal auditors perform compliance or operational audits in order to assuremanagement or the #oard of directors that controls and policies are properly andconsistently developed, applied and evaluated.

1-12 The four parts of the 4niform !"A 7xamination are% Auditing and Attestation, Financial Accounting and &eporting, &egulation, and usiness 7nvironment and !oncepts.

1-13 t is important for !"As to #e knoledgea#le a#out e-commerce technologies #ecausemore of their clients are rapidly expanding their use of e-commerce. 7xamples of commonlyused e-commerce technologies include purchases and sales of goods through the nternet,automatic inventory reordering via direct connection to inventory suppliers, and online #anking.!"As ho perform audits or provide other assurance services a#out information generated iththese technologies need a #asic knoledge and understanding of information technology and e-commerce in order to identify and respond to risks in the financial and other informationgenerated #y these technologies.

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Chapter 2 - The C*A *rofession

2-1 The four ma9or services that !"As provide are%

1. Assurance services Assurance services are independent professional services that

improve the quality of information for decision makers. Assurance servicesinclude attestation services, hich are any services in hich the !"A firm issuesa report that expresses a conclusion a#out the relia#ility of an assertion that isthe responsi#ility of another party. The four categories of attestation services areaudits of historical financial statements, attestation on the effectiveness ofinternal control over financial reporting, revies of historical financial statements,and other attestation services.

+. Accountin an! bookkee"in services Accounting services involve preparing theclients financial statements from the clients records. ookkeeping servicesinclude the preparation of the clients 9ournals and ledgers as ell as financialstatements.

3. #a$ services Tax services include preparation of corporate, individual, and estatereturns as ell as tax planning assistance.

2. Manaement consultin services These services range from suggestions to improvethe clients accounting system to computer installations.

2-2 The ma9or characteristics of !"A firms that permit them to fulfill their social functioncompetently and independently are%

1. Orani%ational form A !"A firm exists as a separate entity to avoid an employer-employee relationship ith its clients. The !"A firm employs a professional staffof sufficient si0e to prevent one client from constituting a significant portion oftotal income and there#y endangering the firms independence.

+. &on!uct A !"A firm employs a professional staff of sufficient si0e to provide a #roadrange of expertise, continuing education, and promotion of a professionalindependent attitude and competence.

3. Peer revie' This practice evaluates the performance of !"A firms in an attempt tokeep competence high.

2-3 The "u#lic !ompany Accounting 'versight oard provides oversight for auditors ofpu#lic companies, including esta#lishing auditing and quality control standards for pu#liccompany audits, and performing inspections of the quality controls at audit firms performingthose audits.

2-4 The purpose of the 5ecurities and 7xchange !ommission is to assist in providinginvestors ith relia#le information upon hich to make investment decisions. 5ince mostreasona#ly large !"A firms have clients that must file reports ith the 57! each year (allcompanies filing registration statements under the securities acts of l?33 and l?32 must fileaudited financial statements and other reports ith the 57! at least once each year), theprofession is highly involved ith the 57! requirements.

The 57! has considera#le influence in setting generally accepted accounting principlesand disclosure requirements for financial statements #ecause of its authority for specifyingreporting requirements considered necessary for fair disclosure to investors. n addition, the57! has poer to esta#lish rules for any !"A associated ith audited financial statementssu#mitted to the !ommission.

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2-+ The A!"A is the organi0ation that sets professional requirements for !"As. The A!"Aalso conducts research and pu#lishes materials on many different su#9ects related toaccounting, auditing, management advisory services, and taxes. The organi0ation also preparesand grades the !"A examinations, provides continuing education to its mem#ers, and developsspecialty designations to help market and assure the quality of services in speciali0ed practice

areas.

2-, 5tatement on 5tandards for Attestation 7ngagements as first issued in 1?@ and itspurposes ere to provide a frameork for attest engagements and to develop standards forthose engagements. n +BB1, the Auditing 5tandards oard issued 55A7 1B in response to theneed for more detailed standards for specific types of attestation services. 55A7 1B supercedesthe previously issued standards and its main purpose is to improve the usefulness of theattestation standards and provide greater flexi#ility to practitioners in providing assuranceservices.

2- The "!A' no has responsi#ility for esta#lishing auditing standards for pu#liccompanies, hile the Auditing 5tandards oard (A5) of the A!"A esta#lishes auditing

standards for private companies. The A5 previously had responsi#ility for esta#lishing auditingstandards for #oth pu#lic and private companies. 7xisting auditing standards ere adopted #ythe "!A' as interim auditing standards for pu#lic company audits.

2-. (enerall) acce"te! au!itin stan!ar!s are ten general guidelines to aid auditors infulfilling their professional responsi#ilities. These guidelines include three general standardsconcerned ith competence, independence, and due professional care< three standards of fieldork including planning and supervision, study and evaluation of internal control, and thegathering of competent evidential matter< and four standards of reporting hich require astatement as to presentation in accordance ith generally accepted accounting principles,inconsistency o#served in the current period in relation to the preceding period, adequatedisclosure, and the expression of an opinion as to the fairness of the presentation of the

financial statements.

(enerall) acce"te! accountin "rinci"les are specific rules for accounting fortransactions occurring in a #usiness enterprise. 7xamples may #e any of the opinions of theFA5.

2-/ Auditors can o#tain adequate technical training and proficiency through formal educationin auditing and accounting, adequate practical experience, and continuing professionaleducation. Auditors can demonstrate their proficiency #y #ecoming licensed to practice as!"As, hich requires successful completion of the 4niform !"A 7xamination. The specificrequirements for licensure vary from state to state.

2-10 For the most part, generally accepted auditing standards are general rather thanspecific. any practitioners along ith critics of the profession #elieve the standards shouldprovide more clearly defined guidelines as an aid in determining the extent of evidence to #eaccumulated. This ould eliminate some of the difficult audit decisions and provide a source ofdefense if the !"A is charged ith conducting an inadequate audit. 'n the other hand, highlyspecific requirements could turn auditing into mechanical evidence gathering, void ofprofessional 9udgment. From the point of vie of #oth the profession and the users of auditingservices, there is pro#a#ly a greater harm from defining authoritative guidelines too specificallythan too #roadly.

,



2-11 nternational 5tandards on Auditing (5As) are issued #y the nternational Auditing"ractices !ommittee (A"!) of the nternational Federation of Accountants (FA!). 5As aredesigned to improve the uniformity of auditing practices and related services throughout theorld #y issuing pronouncements on a variety of audit and attest functions and promoting theiracceptance orldide. A !"A ho conducts an audit in accordance ith :AA5 may not complyith 5As #ecause there may #e additional 5A requirements that extend #eyond :AA5

requirements.

2-12 Cuality controls are the procedures used #y a !"A firm that help it meet its professionalresponsi#ilities to clients. Cuality controls are therefore esta#lished for the entire !"A firm asopposed to individual engagements.

2-13 The element of quality control is personnel management. The purpose of therequirement is to help assure !"A firms that all ne personnel should #e qualified to performtheir ork competently. A !"A firm must have competent employees conducting the audits ifquality audits are to occur.

2-14 A peer revie is a revie, #y !"As, of a !"A firms compliance ith its quality control

system. A mandatory peer revie means that such a revie is required periodically. A!"Amem#er firms are required to have a peer revie every three years. &egistered firms ith the"!A' are su#9ect to quality inspections. These are different than peer revies #ecause theyare performed #y independent inspection teams rather than another !"A firm.

"eer revies can #e #eneficial to the profession and to individual firms. y helping firmsmeet quality control standards, the profession gains if revies result in practitioners doinghigher quality audits. A firm having a peer revie can also gain if it improves the firms practicesand there#y enhances its reputation and effectiveness, and reduces the likelihood of lasuits.'f course peer revies are costly. There is alays a trade off #eteen cost and #enefits. A !"Afirm also gives up some independence of activities hen it is revieed #y another !"A firm.

2-1+ The to divisions of practice that a !"A firm may #elong to are the 57! "ractice5ection (renamed the !enter for "u#lic !ompany Audit Firms) and the "rivate !ompanies"ractice 5ection. A firm may #elong to one section, #oth sections, or neither. any of the self-regulatory activities of the 57!"5 have #een taken over #y the "!A'.

"roponents of this division #elieve that this ill improve the quality of practice #y !"Afirms and that it ill improve self-regulation. !ritics state that it esta#lishes to classes of !"Asand implies a loer performance quality for firms that are not mem#ers of the 57! "ractice5ection.



Chapter 3 - Audit #eports

3-1 Auditors reports are important to users of financial statements #ecause they informusers of the auditors opinion as to hether or not the statements are fairly stated or hether noconclusion can #e made ith regard to the fairness of their presentation. 4sers especially look

for any deviation from the ording of the standard unqualified report and the reasons andimplications of such deviations. 6aving standard ording improves communications for the#enefit of users of the auditor$s report. >hen there are departures from the standard ording,users are more likely to recogni0e and consider situations requiring a modification orqualification to the auditor$s report or opinion.

3-2 The unqualified audit report consists of%

1. Re"ort title Auditing standards require that the report #e titled and that the titleincludes the ord in!e"en!ent .

+. Au!it re"ort a!!ress The report is usually addressed to the company, itsstockholders, or the #oard of directors.

3. Intro!uctor) "arara"h The first paragraph of the report does three things% first,it makes the simple statement that the !"A firm has done an au!it . 5econd, itlists the financial statements that ere audited, including the #alance sheet datesand the accounting periods for the income statement and statement of cashflos. Third, it states that the statements are the responsi#ility of managementand that the auditors responsi#ility is to express an opinion on the statements#ased on an audit.

2. *co"e "arara"h. The scope paragraph is a factual statement a#out hat theauditor did in the audit. The remainder #riefly descri#es important aspects of anaudit.

=. O"inion "arara"h. The final paragraph in the standard report states theauditors conclusions #ased on the results of the audit.

. +ame of &PA firm. The name identifies the !"A firm or practitioner hoperformed the audit.

D. Au!it re"ort !ate. The appropriate date for the report is the one on hich theauditor has completed the most important auditing procedures in the field.

The same seven parts are found in a qualified report as in an unqualified report. Thereare also often one or more additional paragraphs explaining reasons for the qualifications.

3-3 The purposes of the scope paragraph in the auditors report are to inform the financialstatement users that the audit as conducted in accordance ith generally accepted auditingstandards, in general terms hat those standards mean, and hether the audit provides areasona#le #asis for an opinion.

The information in the scope paragraph includes%

1. The auditor folloed generally accepted auditing standards. The audit is designed too#tain reasonable assurance a#out hether the

+. statements are free of material misstatement.3. *iscussion of the audit evidence accumulated.2. 5tatement that the auditor #elieves the evidence accumulated as appropriate for

the circumstances to express the opinion presented.

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3-4 The purpose of the opinion paragraph is to state the auditors conclusions #ased uponthe results of the audit evidence. The most important information in the opinion paragraphincludes%

1. The ords Ein our opinionE hich indicate that the conclusions are #ased on

professional 9udgment.+. A restatement of the financial statements that have #een audited and the dates

thereof or a reference to the introductory paragraph.3. A statement a#out hether the financial statements ere presented fairly and in

accordance ith generally accepted accounting principles.

3-+ The auditors report should #e dated Fe#ruary 1D, +BB, the date on hich the auditorcompleted the most important auditing procedures in the field.

3-, An unqualified report may #e issued under the folloing five circumstances%

1. All statements;#alance sheet, income statement, statement of retained earnings,

and statement of cash flos;are included in the financial statements.+. The three general standards have #een folloed in all respects on the engagement.3. 5ufficient evidence has #een accumulated and the auditor has conducted the

engagement in a manner that ena#les him or her to conclude that the threestandards of field ork have #een met.

2. The financial statements are presented in accordance ith generally acceptedaccounting principles. This also means that adequate disclosures have #eenincluded in the footnotes and other parts of the financial statements.

=. There are no circumstances requiring the addition of an explanatory paragraph ormodification of the ording of the report.

3- The introductory, scope and opinion paragraphs are modified to include reference tomanagement$s report on internal control over financial reporting, and the scope of the auditor$s

ork and opinion on internal control over financial reporting. The introductory and opinionparagraphs also refer to the frameork used to evaluate internal control. To additionalparagraphs are added #eteen the scope and opinion paragraphs that define internal controland descri#e the inherent limitations of internal control.

3-. >hen adherence to generally accepted accounting principles ould result in misleadingfinancial statements there should #e a complete explanation in a separate paragraph. Theseparate paragraph should fully explain the departure and the reason hy generally acceptedaccounting principles ould have resulted in misleading statements. The opinion should #eunqualified, #ut it should refer to the separate paragraph during the portion of the opinion inhich generally accepted accounting principles are mentioned.

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3-/ An unqualified report ith an explanatory paragraph or modified ording is the same asa standard unqualified report e$ce"t that the auditor #elieves it is necessary to provideadditional information a#out the audit or the financial statements. For a qualified report, eitherthere is a scope limitation (condition 1) or a failure to follo generally accepted accountingprinciples (condition +). 4nder either condition, the auditor concludes that the overall financialstatements are fairly presented.

To examples of an unqualified report ith an explanatory paragraph or modifiedording are%

1. The entity changed from one generally accepted accounting principle to anothergenerally accepted accounting principle.

+. A shared report involving the use of other auditors.

3-10 >hen another !"A has performed part of the audit, the primary auditor issues one of thefolloing types of reports #ased on the circumstances.

1. o reference is made to the other auditor. This ill occur if the other auditoraudited an immaterial portion of the statement, the other auditor is knon orclosely supervised, or if the principal auditor has thoroughly revieed the otherauditors ork.

+. ssue a shared opinion in hich reference is made to the other auditor. This typeof report is issued hen it is impractical to revie the ork of the other auditor orhen a portion of the financial statements audited #y the other !"A is material inrelation to the total.

3. The report may #e qualified if the principal auditor is not illing to assume anyresponsi#ility for the ork of the other auditor. A disclaimer may #e issued if thesegment audited #y the other !"A is highly material.

3-11 7ven though the prior year statements have #een restated to enhance compara#ility, aseparate explanatory paragraph is required to explain the change in generally acceptedaccounting principles in the first year in hich the change took place.

3-12 !hanges that affect the consistency of the financial statements may involve any of thefolloing%

a. !hange in accounting principle#. !hange in reporting entityc. !orrections of errors involving accounting principles.

An example of a change that affects consistency ould #e a change in the method ofcomputing depreciation from straight line to an accelerated method. A separate explanatoryparagraph is required if the amounts are material.

!ompara#ility refers to items such as changes in estimates, presentation, and eventsrather than changes in accounting principles. For example, a change in the estimated life of adeprecia#le asset ill affect the compara#ility of the statements. n that case, no explanatoryparagraph for lack of consistency is needed, #ut the information may require disclosure in thestatements.

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3-13 The three conditions requiring a departure from an unqualified opinion are%

1. #he sco"e of the au!it has been restricte! . 'ne example is hen the client illnot permit the auditor to confirm material receiva#les. Another example is henthe engagement is not agreed upon until after the clients year-end hen it may#e impossi#le to physically o#serve inventories.

+. #he financial statements have not been "re"are! in accor!ance 'ith enerall)acce"te! accountin "rinci"les. An example is hen the client insists upon usingreplacement costs for fixed assets.

3. #he au!itor is not in!e"en!ent . An example is hen the auditor ons stock inthe clients #usiness.

3-14 A ,ualifie! o"inion states that there has #een either a limitation on the scope of the auditor a departure from :AA" in the financial statements, #ut that the auditor #elieves that theoverall financial statements are fairly presented. This type of opinion may not #e used if theauditor #elieves the exceptions #eing reported upon are extremely material, in hich case adisclaimer or adverse opinion ould #e used.

An a!verse o"inion states that the auditor #elieves the overall financial statements are

so materially misstated or misleading that they do not present fairly in accordance ith :AA"the financial position, results of operations, or cash flos.

A !isclaimer of o"inion states that the auditor has #een una#le to satisfy him or herselfas to hether or not the overall financial statements are fairly presented #ecause of a significantlimitation of the scope of the audit, or a nonindependent relationship under the &o!e ofProfessional &on!uct #eteen the auditor and the client.

7xamples of situations that are appropriate for each type of opinion are as follos%

O*!N!ON T* A%*) S!T"AT!ON

*isclaimer aterial physical inventories not o#served

and the inventory cannot #e verifiedthrough other procedures.

ack of independence #y the auditor.

Adverse A highly material departure from :AA".

Cualified na#ility to confirm the existence of anasset hich is material #ut not extremelymaterial in value.

3-1+ The common definition of materiality as it applies to accounting and, therefore, to auditreporting is%

A misstatement in the financial statements can #e considered material ifknoledge of the misstatement ould affect a decision of a reasona#le user ofthe statements.

!onditions that affect the auditors determination of materiality include%

"otential users of the financial statements

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3-1+ continued

*ollar amounts of the folloing items% net income #efore taxes, total assets,current assets, current lia#ilities, and oners equity

ature of the potential misstatements;certain misstatements, such as fraud, arelikely to #e more important to users of the financial statements than other

misstatements.

3-1, ateriality for lack of independence in audit reporting is easiest to define. f the auditorlacks independence as defined #y the &o!e of Professional &on!uct , it is alays consideredhighly material and therefore a disclaimer of opinion is alays necessary. That is, either the !"Ais independent or not independent. For failure to follo :AA", there are three levels ofmateriality% immaterial, material, and highly material.

3-1 The auditors opinion may #e qualified #y scope limitations caused #y client restrictionsor #y limitations resulting from conditions #eyond the clients control. The former occurs henthe client ill not, for example, permit the auditor to confirm material receiva#les or physicallyo#serve inventories. The latter may occur hen the engagement is not agreed upon until after

the clients year-end hen it may not #e possi#le to physically o#serve inventories or confirmreceiva#les.

A disclaimer of opinion is issued if the scope limitation is so material that the auditorcannot determine if the overall financial statements are fairly presented. f the scope limitation iscaused #y the clients restriction the auditor should #e aare that the reason for the restrictionmight #e to deceive the auditor. For this reason, a disclaimer is more likely for client restrictionsthan for conditions #eyond anyones control.

>hen there is a scope restriction that results in the failure to verify material, #ut notpervasive accounts, a qualified opinion may #e issued. This is more likely hen the scopelimitation is for conditions #eyond the clients control than for restrictions #y the client.

3-1. A report ith a scope and an opinion qualification is issued hen the auditor can neitherperform procedures that he or she considers necessary nor satisfy him or herself #y usingalternative procedures, due to the existence of conditions #eyond the clients or the auditorscontrol, #ut the amount involved in the financial statements is not highly material. An importantpart of a scope and opinion qualification is that it results from not accumulating sufficient auditevidence, either #ecause of the clients request or #ecause of circumstances #eyond anyonescontrol.

A report qualified as to opinion only results hen the auditor has accumulated sufficientcompetent evidence #ut has concluded that the financial statements are not correctly stated.The only circumstance in hich an opinion only qualification is appropriate is for material, #utnot highly material, departures from :AA".

3-1/ The three alternative opinions that may #e appropriate hen the clients financialstatements are not in accordance ith :AA" are an unqualified opinion, qualified as to opiniononly and adverse opinion. *etermining hich is appropriate depends entirely upon materiality.

An unqualified opinion is appropriate if the :AA" departure is immaterial (standard unqualified)or if the auditor agrees ith the clients departure from :AA" (unqualified ith explanatoryparagraph). A qualified opinion is appropriate hen the deviation from :AA" is material #ut nothighly material< the adverse opinion is appropriate hen the deviation is highly material.

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3-20 The A!"A has such strict requirements on audit opinions hen the auditor is notindependent #ecause it is important that stockholders and other third parties #e a#solutelyassured that the auditor is un#iased throughout the entire engagement. f users develop theattitude that auditors are not independent of management, the value of the audit function ill #egreatly reduced, if not eliminated.

3-21 >hen the auditor discovers more than one condition that requires a departure from or amodification of a standard unqualified report, the report should #e modified for each condition.

An exception is hen one condition neutrali0es the other condition. An example ould #e henthe auditor is not independent and there is also a scope limitation. n this situation the lack ofindependence overshados the scope limitation. Accordingly, the scope limitation should not #ementioned.

3-22 4nder current auditing standards, auditors are not required to read information containedin electronic sites, such as the company$s >e# site, that also contain the company$s auditedfinancial statements and the auditor$s report. Auditing standards do not consider electronic sitesto #e Gdocuments.H This is different from the auditor$s responsi#ility for pu#lished (hard copy)documents that contain information in addition to audited financial statements and the auditor$s

report. n this latter example, the auditor is responsi#le for reading other information that ispu#lished ith audited financial statements and the auditor$s report to determine hether it ismaterially inconsistent ith information in the audited financial statements.

Chapter 4 - *rofessiona thics

4-1 The six core ethical values descri#ed #y the 8osephson nstitute are%

1. Trustorthiness 2. Fairness+. &espect =. !aring3. &esponsi#ility . !iti0enship

There are many other potential sources of ethical values, including las and regulations,church doctrines, codes of professional ethics, and individual organi0ations$ codes of conduct.

4-2 An ethical dilemma is a situation that a person faces in hich a decision must #e madea#out the appropriate #ehavior. There are many possi#le ethical dilemmas that one can face,such as finding a allet containing money, or dealing ith a supervisor ho asks you to orkhours ithout recording them.

An ethical dilemma can #e resolved using the six-step approach outlined on p. D of thetext. The six steps are%

1. '#tain the relevant facts.+. dentify the ethical issues from the facts.3. *etermine ho is affected #y the outcome of the dilemma and ho each person or

group is affected.2. dentify the alternatives availa#le to the person ho must resolve the dilemma.=. dentify the likely consequence of each alternative.. *ecide the appropriate action.

13



4-3 There is a special need for ethical #ehavior #y professionals to maintain pu#licconfidence in the profession, and in the services provided #y mem#ers of that profession. Theethical requirements for !"As are similar to the ethical requirements of other professions. Allprofessionals are expected to #e competent, perform services ith due professional care, andrecogni0e their responsi#ility to clients. The ma9or difference #eteen other professional groupsand !"As is independence. ecause !"As have a responsi#ility to financial statement users, it

is essential that auditors #e independent in fact and appearance. ost other professionals, suchas attorneys, are expected to #e an advocate for their clients.

4-4

*A#T *"#*OS

1. "rinciples of "rofessional!onduct

1. "rovide ideal standards of ethical conduct andhelp practitioners understand the idealconduct of a !"A.

+. &ules of conduct +. "rovide minimum standards of ethical conduct

stated as specific rules.3. nterpretation of the rules

of conduct3. "rovide formal interpretations of the rules of

conduct to anser questions that frequentlyarise a#out the rules of conduct.

2. 7thical rulings 2. "rovide more detailed guidance topractitioners a#out interpretation of the rulesof conduct for less commonly raisedquestions.

4-+ In!e"en!ence in fact exists hen the auditor is actually a#le to maintain an un#iased

attitude throughout the audit, hereas in!e"en!ence in a""earance is dependent on othersinterpretation of this independence and hence their faith in the auditor. Activities hich may not affect independence in fact, #ut hich are likely to affect

independence in appearance are% (otice that the first to are violations of the &o!e ofProfessional &on!uct .)

1. 'nership of a financial interest in the audited client.+. *irectorship or officer of an audit client.3. "erformance of management advisory or #ookkeeping or accounting services and

audits for the same company.2. *ependence upon a client for a large percentage of audit fees.=. 7ngagement of the !"A and payment of audit fees #y management.

4-, ndependence in auditing means taking an un#iased viepoint. 4sers of financialstatements ould #e unlikely to rely on the statements if they #elieved auditors ere #iased inissuing audit opinions.

14



4- Auditors of pu#lic companies are prohi#ited from performing the folloing nonauditservices%

1. ookkeeping and other accounting services+. Financial information systems design and implementation

3. Appraisal or valuation services2. Actuarial services=. nternal audit outsourcing. anagement or human resource functionsD. roker or dealer or investment adviser, or investment #anker services@. egal and expert services unrelated to the audit?. Any other service that the "!A' determines #y regulation is impermissi#le

onaudit services that are not prohi#ited #y the 5ar#anesI'xley Act and the 57! rulesmust #e pre-approved #y the company$s audit committee. n addition, an accountant is notindependent of an audit client if an audit partner received compensation #ased on sellingengagements to that client for services other than audit, revie and attest services.

!ompanies are required to disclose in their proxy statement or annual filings ith the57! the total amount of audit and nonaudit fees paid to the audit firm for the to most recentyears. Four categories of fees are to #e reported% (1) audit fees< (+) audit-related fees< (3) taxfees< and (2) all other fees. !ompanies are also required to provide further #reakdon of theGother feesH category, and provide qualitative information on the nature of the services provided.

4-. The rules concerning stock onership #y partners and professional staff%

A partner in the office of the partner responsi#le for an audit engagement cannot onstock in that audit client. A partner can on stock in an audit client, as long as (1) he or shecannot influence the audit engagement and (+) he or she is not in the same office as the partner

responsi#le for the audit engagement. A professional staff mem#er cannot on stock in an audit client if he or she is assignedto the engagement or if he or she #ecomes a partner in the office of the partner responsi#le forthe audit engagement. A professional staff mem#er can on stock in a firm$s audit client as longas he or she does not participate in the audit engagement.

Partner violation% A partner in the 5an Francisco office ons one share of stock of a clienthose audit is conducted #y a different partner in the 5an Francisco office.

Professional staff violation% An audit manager ons stock in a client hose audit is performed #ythe office here the audit manager orks. The manager is promoted to partner mid-year. Assoon as the manager #ecomes a partner, there is a violation of &ule 1B1.

4-/ >ays to reduce the appearance of the lack of independence are% the use of an auditcommittee to select auditors made up of directors ho are not a part of management< arequirement that all changes of auditors and reasons therefore #e reported to the 57! or otherregulatory agency< and approval of the !"A firm #y stockholders at the annual meeting. The5ar#anesI'xley act requires that the audit committee of a pu#lic company consist only ofindependent mem#ers and #e responsi#le for the appointment, termination, and compensationof the audit firm.

1+



4-10 A !"A firm has several options hen it decides it is not competent to perform an audit%

1. >ithdra from the engagement.+. '#tain the expertise through continuing education and self-studies.3. 6ire someone ho has the expertise.2. >ork on a consulting #asis ith another !"A firm.

4-11 A fee #ased upon the amount of time it takes to complete is not a violation of &ule 3B+.&ule 3B+ on contingent fees states that professional services for clients receiving assertionopinions shall not #e offered or rendered under an agreement here#y no fee ill #e chargedunless a specific finding or result is attained, or here the fee is otherise contingent upon thefindings or results of such services. The purpose of the rule is to prevent sacrificing the qualityof audits #ecause of the pressure felt #y the auditor in producing the required audit outcome. Anexample ould #e the fee #eing dependent upon the issuance of an unqualified opinion or theo#taining of a loan #y a client.

4-12 The folloing are exceptions to the confidentiality requirement for the !"As audit files%

1. The confidentiality requirement cannot interfere ith the mem#ers o#ligation tofollo auditing standards or generally accepted accounting principles.

+. A mem#er must comply ith a validly issued su#poena or summons enforcea#le #yorder of a court.

3. A revie of a mem#ers professional practice under A!"A or state !"A society orstate oard of Accountancy authori0ation is permitted.

2. A mem#er must respond to any inquiry made #y the ethics division or trial #oard ofthe nstitute or a duly constituted investigative or disciplinary #ody of a state !"Asociety or oard of Accountancy.

4-13 Audits should #e maintained at a high level of quality even if solicitation, advertising, andcompetitive #idding are alloed for several reasons%

1. "rofessionals do high quality ork #ecause it is a characteristic of #eing aprofessional.

+. A reputation of doing high quality ork usually pays off in more clients and a moreprofita#le practice.

3. "otential legal lia#ility is also a deterrent to su#standard ork.2. The &o!e of Professional &on!uct requires a high quality of performance.

4-14 A mem#er is permitted to advertise #y &ule =B+ except in a false, misleading, ordeceptive manner. nterpretation =B+-+ clarifies the meaning of false, misleading or deceptiveacts, including activities that%

1. !reate false or un9ustified expectations of favora#le results.+. mply the a#ility to influence any court, tri#unal, regulatory agency or similar #ody or

official.3. !ontain a representation that specific professional services ill #e performed for a

stated fee, hen it as likely at the time of the representation that such feesould #e su#stantially increased and the prospective client as not informed ofthat likelihood.

2. !ontain any other representations that ould #e likely to cause a reasona#le personto misunderstand or #e deceived.

1,



>hen engagements are o#tained through the efforts of third parties, nterpretation =B+-=indicates that the mem#er has the responsi#ility to ascertain that all promotional efforts areithin the #ounds of the &ules of !onduct.

4-1+ "rohi#iting paying commissions to o#tain clients ho receive attestation services in &ule

=B3 is intended to discourage overly aggressive o#taining of clients #y giving Efinders feesE to#anks and others in a position to give #usiness rather than on the #asis of competitive and other qualifications. "rohi#iting receiving commissions for referrals to other !"As or other providers of services here attestation services are provided is intended to discourage referrals to others onthe #asis of a Esales commissionE rather than the competition of those offering services.!ommissions hen attestation services are not provided are permitted to encouragecompetition for these types of services.

4-1, A !"A may practice in one of the folloing forms%

1. A proprietorship+. A general partnership

3. A general corporation (if permitted #y state la)2. A professional corporation=. imited lia#ility company (if permitted #y state la). imited lia#ility partnership (if permitted #y state la)

4-1 There are ma9or differences #eteen the nature of the enforcement #y the A!"A and astate oard of Accountancy.

A!"A enforcement% A eighty social sanction #ecause violations are pu#lished inthe !"A esletter. 6oever, A!"A enforcement #y itself ill not prevent a !"Afrom practicing pu#lic accounting. The A!"A can remove a practitioner from

A!"A mem#ership, #ut not eliminate the right to practice.

5tate oard of Accountancy enforcement% A state oard may revoke a practitionerslicense to practice pu#lic accounting.

1



Chapter + - )e5a )ia6iit7

+-1 5everal factors that have affected the increased num#er of lasuits against !"As are%

1. The groing aareness of the responsi#ilities of pu#lic accountants on the part ofusers of financial statements.

+. An increased consciousness on the part of the 57! regarding its responsi#ility forprotecting investors interests.

3. The greater complexities of auditing and accounting due to the increasing si0e of#usinesses, the glo#ali0ation of #usiness, and the intricacies of #usinessoperations.

2. 5ocietys increasing acceptance of lasuits.=. arge civil court 9udgments against !"A firms, hich have encouraged attorneys to

provide legal services on a contingent fee #asis.. The illingness of many !"A firms to settle their legal pro#lems out of court.D. The difficulty courts have in understanding and interpreting technical accounting and

auditing matters.

+-2 The most important positive effects are the increased quality control #y !"A firms that islikely to result from actual and potential lasuits and the a#ility of in9ured parties to receiveremuneration for their damages. egative effects are the energy required to defend groundlesscases and the harmful impact on the pu#lics image of the profession. egal lia#ility may alsoincrease the cost of audits to society, #y causing !"A firms to increase the evidenceaccumulated.

+-3 usiness failure is the risk that a #usiness ill fail financially and, as a result, ill #euna#le to pay its financial o#ligations. Audit risk is the risk that the auditor ill conclude that thefinancial statements are fairly stated and an unqualified opinion can therefore #e issued hen,in fact, they are materially misstated.

>hen there has #een a #usiness failure, #ut not an audit failure, it is common for

statement users to claim there as an audit failure, even if the most recently issued auditedfinancial statements ere fairly stated. any auditors evaluate the potential for #usiness failurein an engagement in determining the appropriate audit risk.

+-4 The prudent person concept states that a person is responsi#le for conducting a 9o# ingood faith and ith integrity, #ut is not infalli#le. Therefore, the auditor is expected to conduct anaudit using due care, #ut does not claim to #e a guarantor or insurer of financial statements.

+-+ The difference #eteen fraud and constructive fraud is that in fraud the rongdoerintends to deceive another party hereas in constructive fraud there is a lack of intent todeceive or defraud. !onstructive fraud is highly negligent performance.

+-, any !"A firms illingly settle lasuits out of court in an attempt to minimi0e legal costsand avoid adverse pu#licity. This has a negative effect on the profession hen a !"A firmagrees to settlements even though it #elieves that the firm is not lia#le to the plaintiffs. Thisencourages others to sue !"A firms here they pro#a#ly ould not to such an extent if thefirms had the reputation of contesting the litigation. Therefore, out-of-court settlementsencourage more lasuits and, in essence, increase the auditors lia#ility #ecause many firmsill pay even though they do not #elieve they are lia#le.

1.



+- An auditors #est defense for failure to detect a fraud is an audit properly conducted inaccordance ith auditing standards. 5A5 ?? (A4 31) states that the auditor should assess therisk of material misstatements of the financial statements due to fraud. ased on thisassessment, the auditor should design the audit to provide reasonable assurance of detectingmaterial misstatements due to fraud. 5A5 ?? also states that #ecause of the nature of fraud(including defalcations), a properly designed and executed audit may not detect a material

misstatement due to fraud.

+-. !ontri#utory negligence used in legal lia#ility of auditors is a defense used #y the auditor hen he or she claims the client or user also had a responsi#ility in the legal case. An exampleis the claim #y the auditor that management kne of the potential for fraud #ecause ofeaknesses in internal control, #ut refused to correct them. The auditor there#y claims that theclient contri#uted to the fraud #y not correcting material eaknesses in internal control.

+-/ An engagement letter from the auditor to the client specifies the responsi#ilities of #othparties and states such matters as fee arrangements and deadlines for completion. The auditormay also use this as an opportunity to inform the client that the responsi#ility for the preventionof fraud is that of the client. A ell-ritten engagement letter can #e useful evidence in the case

of a lasuit, given that the letter spells out the terms of the engagement agreed to #y #othparties. >ithout an engagement letter, the terms of the engagement are easily disputed.

+-10 ia#ility to clients under common la has remained relatively unchanged for many years.f a !"A firm #reaches an implied or expressed contract ith a client, there is a legalresponsi#ility to pay damages. Traditionally the distinction #eteen privity of contract ith clientsand lack of privity of contract ith third parties as essential in common la. The lack of privityof contract ith third parties meant that third parties ould have no rights ith respect toauditors except in the case of gross negligence.

That precedent as esta#lished #y the 4ltramares case. n recent years some courtshave interpreted 4ltramares more #roadly to allo recovery #y third parties if those third partiesere knon and recogni0ed to #e relying upon the ork of the professional at the time the

professional performed the services (foreseen users). 5till others have re9ected the 4ltramaresdoctrine entirely and have held the !"A lia#le to anyone ho relies on the !"A$s ork, if thatork is performed negligently. The lia#ility to third parties under common la continues in astate of uncertainty. n some 9urisdictions the precedence of 4ltramares is still recogni0edhereas in others there is no significant distinction #eteen lia#ility to third parties and to clientsfor negligence.

+-11 n recent years the auditors lia#ility to a third party has #ecome affected #y hether theparty is knon or unknon. o a knon third party, under common la, usually has the samerights as the party that is privy to the contract. An unknon third party usually has feer rights.The approach folloed in most states is the Restatement of #orts approach to the foreseenusers concept. 4nder the Restatement of #orts approach, foreseen users must #e mem#ers of

a reasona#ly limited and identifia#le group of users that have relied on the !"A$s ork, eventhough those persons ere not specifically knon to the !"A at the time the ork as done.

1/



+-12 The differences #eteen the auditors lia#ility under the securities acts of 1?33 and 1?32are #ecause the 1?33 act imposes a heavier #urden on the auditor. Third party rights aspresented in the 1?33 act are%

1. Any third party ho purchases securities descri#ed in the registration statement maysue the auditor.

+. Third party users do not have the #urden of proof that they relied on the financialstatements or that the auditor as negligent or fraudulent in doing the audit. Theymust only prove that the financial statements ere misleading or not fairly stated.

n con9unction ith these third party rights, the auditor has a greater #urden in that he orshe must demonstrate that%

1. The statements are not materially misstated.+. An adequate audit as conducted.3. The user did not incur the loss #ecause of misleading financial statements.

The lia#ility of auditors under the 1?32 act is not as harsh as under the 1?33 act. n this

instance, the #urden of proof is on third parties to sho that they relied on the statements andthat the misleading statements ere the cause of the loss.

The principal focus of accountants$ lia#ility under the 1?32 act is on &ule 1B#-=. 4nder&ule 1B#-=, accountants enerall) can only #e held lia#le if they intentionally or recklesslymisrepresent information intended for third-party use. any lasuits involving accountants$lia#ility under &ule 1B#-= have resulted in accountants #eing lia#le hen they kne all of therelevant facts, #ut merely made poor 9udgments. n recent years, hoever, courts have decidedthat poor 9udgment doesn$t necessarily prove fraud on the part of the accountant.

+-13 The auditors leal liabilit) to the client can result from the auditors failure to properlyfulfill his or her contract for services. The lasuit can #e for #reach of contract, hich is a claimthat the contract as not performed in the manner agreed upon, or it can #e a tort action for

negligence. An example ould #e the clients detection of a misstatement in the financialstatements, hich ould have #een discovered if the auditor had performed all audit proceduresrequired in the circumstances (e.g., misstatement of inventory resulting from an inaccuratephysical inventory not properly o#served #y the auditor).

The auditors liabilit) to thir! "arties un!er common la' results from any loss incurred #ythe claimant due to reliance upon misleading financial statements. An example ould #e a #ankthat has loans outstanding to an audited company. f the audit report did not disclose that thecompany had contingent lia#ilities that su#sequently #ecame real lia#ilities and forced thecompany into #ankruptcy, the #ank could proceed ith legal action against the auditors for thematerial omission.

&ivil liabilit) un!er the *ecurities Act of .// provides the right of third parties to sue theauditor for damages if a registration statement or a prospectus contains an untrue statement of

a material fact or omits to state a material fact that ould result in misleading financialstatements. The third party does not have to prove reliance upon the statements or even shohis or her loss resulted from the misstatement. An example ould #e stock purchased #y aninvestor in hat appears, #ased upon audited financial statements, to #e a sound company. fthe financial statements are later found to #e inaccurate or misleading, and the investment losesvalue as a result of a situation existing #ut not disclosed at the date of the financial statements,the investor could file legal proceedings against the auditor for negligence.

20



+-13 continued

&ivil liabilit) un!er the *ecurities Act of ./0 relates to audited financial statementsissued to the pu#lic in annual reports or 1B-J reports. &ule 1B#-= of the Act prohi#its fraudulentactivity #y direct sellers of securities. 5everal federal court decisions have extended theapplication of &ule 1B#-= to accountants, underriters and others. An example ould #e an

auditor knoingly permitting the issuance of fraudulent financial statements of a pu#licly heldclient.

&riminal liabilit) of the auditor may result from federal or state las if the auditordefrauds another person through knoingly #eing involved ith false financial statements. Anexample of an act that could result in criminal lia#ility ould #e an auditors certifying financialstatements that he or she knos overstate income for the year and the financial position of thecompany at the audit date.

+-14 The 57! can impose the folloing sanctions against a !"A firm%

1. 5uspend the right to conduct audits of 57! clients.+. "rohi#it a firm from accepting any ne clients for a period.

3. &equire a revie of the firms practice #y another !"A firm.2. &equire firms to participate in continuing education programs.

+-1+ 5ome of the ays in hich the profession can positively respond and reduce lia#ility inauditing are%

1. !ontinued research in auditing.+. 5tandards and rules must #e revised to meet the changing needs of auditing.3. The A!"A can esta#lish requirements that the #etter practitioners alays follo in

an effort to increase the overall quality of auditing.2. 7sta#lish ne peer revie requirements.=. !"A firms should oppose all unfounded lasuits rather than settling out of court.

. 4sers of financial statements need to #e #etter educated regarding the attestfunction.

D. mproper conduct and performance #y mem#ers must #e sanctioned.@. o##y for changes in state and federal las concerning accountants$ lia#ility.

Chapter , - Audit #esponsi6iities and O68ectives

,-1 The o#9ective of the audit of financial statements #y the independent auditor is theexpression of an opinion on the fairness ith hich the financial statements present financialposition, results of operations, and cash flos in conformity ith generally accepted accountingprinciples.

The auditor meets that o#9ective #y accumulating sufficient competent evidence to

determine hether the financial statements are fairly stated.

,-2 t is managements responsi#ility to adopt sound accounting policies, maintain adequateinternal control and make fair representations in the financial statements. The auditorsresponsi#ility is to conduct an audit of the financial statements in accordance ith auditingstandards and report the findings of the audit in the auditors report.

21



,-3 An error is an unintentional misstatement of the financial statements. Fraud representsintentional misstatements. The auditor is responsi#le for o#taining reasona#le assurance thatmaterial misstatements in the financial statements are detected, hether those misstatementsare due to errors or fraud1

An audit must #e designed to provide reasona#le assurance of detecting materialmisstatements in the financial statements. Further, the audit must #e planned and performed

ith an attitu!e of "rofessional ske"ticism in all aspects of the engagement. ecause there is anattempt at concealment of fraud, material misstatements due to fraud are usually more difficultto uncover than errors. The auditor$s #est defense hen material misstatements (either errors or fraud) are not uncovered in the audit is that the audit as conducted in accordance ith auditingstandards.

,-4 isappropriation of assets represents the theft of assets #y employees. Fraudulentfinancial reporting is the intentional misstatement of financial information #y management or atheft of assets #y management, hich is covered up #y misstating financial statements.

isappropriation of assets ordinarily occurs either #ecause of inadequate internalcontrols or a violation of existing controls. The #est ay to prevent theft of assets is throughadequate internal controls that function effectively. any times theft of assets is relatively small

in dollar amounts and ill have no effect on the fair presentation of financial statements. Thereare also the cases of large theft of assets that result in #ankruptcy to the company. Fraudulentfinancial reporting is inherently difficult to uncover #ecause it is possi#le for one or moremem#ers of management to override internal controls. n many cases the amounts areextremely large and may affect the fair presentation of financial statements.

,-+ True, the auditor must rely on management for certain information in the conduct of hisor her audit. 6oever, the auditor must not accept managements representations #lindly. Theauditor must, henever possi#le, o#tain competent evidential matter to support therepresentations of management. As an example, if management represents that certaininventory is not o#solete, the auditor should #e a#le to examine purchase orders fromcustomers that prove part of the inventory is #eing sold at a price that is higher than the

companys cost plus selling expenses. f management represents an account receiva#le as#eing fully collecti#le, the auditor should #e a#le to examine su#sequent payments #y thecustomer or correspondence from the customer that indicates a illingness and a#ility to pay

22



,-,

C&A#ACT#!ST!C A"D!T ST*S

1. anagement$s characteristics andinfluence over the control

environment.

nvestigate the past history of the firm andits management.

*iscuss the possi#ility of fraudulentfinancial reporting ith previous auditorand company legal counsel after o#tainingpermission to do so from management.

+. ndustry conditions. &esearch current status of industry andcompare industry financial ratios to thecompany$s ratios. nvestigate any unusualdifferences.

&ead A!"A$s In!ustr) Au!it Risk Alert forthe company$s industry, if availa#le.!onsider the impact of specific risks that

are identified on the conduct of the audit.3. 'perating characteristics and

financial sta#ility. "erform analytical procedures to evaluate

the possi#ility of #usiness failure. nvestigate hether material transactions

occur close to year-end.

,- The cycle approach is a method of dividing the audit such that closely related types oftransactions and account #alances are included in the same cycle. For example, sales, salesreturns, and cash receipts transactions and the accounts receiva#le #alance are all a part of thesales and collection cycle. The advantages of dividing the audit into different cycles are to dividethe audit into more managea#le parts, to assign tasks to different mem#ers of the audit team,

and to keep closely related parts of the audit together.

,-.

GN#A) )DG# ACCO"NT CC)

5ales Accounts "aya#le&etained 7arnings

Accounts &eceiva#lenventory&epairs K aintenance

5ales K !ollection Acquisition K "ayment!apital Acquisition K &epayment5ales K !ollectionnventory K >arehousing

Acquisition K "ayment

,-/ There is a close relationship #eteen each of these accounts. 5ales, sales returns andalloances, and cash discounts all affect accounts receiva#le. Alloance for uncollecti#leaccounts is closely tied to accounts receiva#le and should not #e separated. ad de#t expenseis closely related to the alloance for uncollecti#le accounts. To separate these accounts fromeach other implies that they are not closely related. ncluding them in the same cycle helps theauditor keep their relationships in mind.

23



,-10 anagement assertions are implied or expressed representations #y managementa#out classes of transactions and the related accounts in the financial statements. Theseassertions are part of the criteria management uses to record and disclose accountinginformation in financial statements. 5A5 31 (A4 3+) classifies five #road categories ofassertions%

1. 7xistence or occurrence+. !ompleteness3. /aluation or allocation2. &ights and o#ligations=. "resentation and disclosure

,-11 :eneral audit o#9ectives follo from and are closely related to management assertions.:eneral audit o#9ectives, hoever, are intended to provide a frameork to help the auditoraccumulate sufficient competent evidence required #y the third standard of field ork. Audito#9ectives are more useful to auditors than assertions #ecause they are more detailed and moreclosely related to helping the auditor accumulate sufficient competent evidence.

,-12

#CO#D!NG %!SSTAT%NT

T#ANSACT!ON-#)ATD A"D!TO9:CT!V V!O)ATD

Fixed asset repair is recorded on the rongdate.

&epair is capitali0ed as a fixed assetinstead of an expense.

Timing

!lassification

,-13 The existence o#9ective deals ith hether amounts included in the financial statementsshould actually #e included. !ompleteness is the opposite of existence. The completenesso#9ective deals ith hether all amounts that should #e included have actually #een included.

n the audit of accounts receiva#le, a nonexistent account receiva#le ill lead tooverstatement of the accounts receiva#le #alance. Failure to include a customers accountreceiva#le #alance, hich is a violation of completeness, ill lead to understatement of theaccounts receiva#le #alance.

,-14 5pecific audit o#9ectives are the application of the general audit o#9ectives to a givenclass of transactions or account #alance. There must #e at least one specific audit o#9ective foreach general audit o#9ective and in many cases there should #e more. 5pecific audit o#9ectives

for a class of transactions or an account #alance should #e designed such that, once they have#een satisfied, the related general audit o#9ective should also have #een satisfied for that classof transactions or account.

,-1+ For the specific #alance-related audit o#9ective, all recorded fixed assets exist at the#alance sheet date, the management assertion and the general #alance-related audit o#9ectiveare #oth Eexistence.E

24



,-1, anagement assertions and general #alance-related audit o#9ectives are consistent forall asset accounts for every audit. They ere developed #y the Auditing 5tandards oard,practitioners, and academics over a period of time. 'ne or more specific #alance-related audito#9ectives are developed for each general #alance-related audit o#9ective in an audit area suchas accounts receiva#le. For any given account, a !"A firm may decide on a consistent set ofspecific #alance-related audit o#9ectives for accounts receiva#le, or it may decide to use

different o#9ectives for different audits.

,-1 The four phases of the audit are%

1. "lan and design an audit approach.+. "erform tests of controls and su#stantive tests of transactions.3. "erform analytical procedures and tests of details of #alances.2. !omplete the audit and issue an audit report.

The auditor uses these four phases to meet the overall o#9ective of the audit, hich is toexpress an opinion on the fairness ith hich the financial statements present fairly, in allmaterial respects, the financial position, results of operations and cash flos in conformity ith

:AA". y accumulating sufficient competent evidence for each audit o#9ective, the overallo#9ective is met. The accumulation of evidence is accomplished #y performing the four phasesof the audit.

Chapter - Audit vidence

-1 n #oth a legal case and in an audit of financial statements, evidence is used #y anun#iased person to dra conclusions. n addition, the consequences of an incorrect decision in#oth situations can #e equally undesira#le. For example, if a guilty person is set free, societymay #e in danger if the person repeats his or her illegal act. 5imilarly, if investors rely onmaterially misstated financial statements, they could lose significant amounts of money. Finally,

the guilt of a defendant in a legal case must #e proven #eyond a reasona#le dou#t. This issimilar to the concept of sufficient competent evidence in an audit situation. As ith a 9udge or

9ury, an auditor cannot #e completely convinced that his or her opinion is correct, #ut rathermust o#tain a high level of assurance.

The nature of evidence in a legal case and in an audit of financial statements differs#ecause a legal case relies heavily on testimony #y itnesses and other parties involved. >hileinquiry is a form of evidence used #y auditors, other more relia#le types of evidence such asconfirmation ith third parties, physical examination, and documentation are also usedextensively. A legal case also differs from an audit #ecause of the nature of the conclusionsmade. n a legal case, a 9udge or 9ury decides the guilt or innocence of the defendant. n anaudit, the auditor issues one of several audit opinions after evaluating the evidence.

-2 The four ma9or audit evidence decisions that must #e made on every audit are%

1. >hich audit procedures to use.+. >hat sample si0e to select for a given procedure.3. >hich items to select from the population.2. >hen to perform the procedure.

2+



-3 An audit procedure is the detailed instruction for the collection of a type of audit evidencethat is to #e o#tained. ecause audit procedures are the instructions to #e folloed inaccumulating evidence, they must #e orded carefully to make sure the instructions are clear.

-4 An audit program for accounts receiva#le is a list of audit procedures that ill #e used toaudit accounts receiva#le for a given client. The audit procedures, sample si0e, items to select,

and timing should #e included in the audit program.

-+ 5ufficient competent evidential matter is to #e o#tained through inspection, o#servation,inquiries and confirmations to afford a reasona#le #asis for an opinion regarding the financialstatements under audit. There are three ma9or phrases of the standard.

*&#AS %AN!NG O$ *&#AS

5ufficient competent evidence The auditor must o#tain evidence that isrelia#le and there must #e a reasona#lequantity of that evidence.

Through inspection, o#servation, inquiriesand confirmations

These are the ma9or types of evidenceavaila#le for the auditor to use.

To afford a reasona#le #asis for anopinion regarding the financial statements

The auditor cannot expect to #ecompletely certain that the financialstatements are fairly presented #ut theremust #e persuasive evidence. Thecollection of evidence gathered #y theauditor provides the #asis for the auditorsopinion.

-, There are to primary reasons hy the auditor can only #e persuaded ith a reasona#lelevel of assurance, rather than #e convinced that the financial statements are correct%

1. The cost of accumulating evidence. t ould #e extremely costly for the auditor togather enough evidence to #e completely convinced.

+. 7vidence is normally not sufficiently relia#le to ena#le the auditor to #e completelyconvinced. For example, confirmations from customers may come #ack itherroneous information, hich is the fault of the customer rather than the client.

- The to determinants of the persuasiveness of evidence are competency andsufficiency. !ompetency refers to the degree to hich evidence can #e considered #elieva#le or

orthy of trust. !ompetency relates to the audit procedures selected, including the timing ofhen those procedures are performed. 5ufficiency refers to the quantity of evidence and it isrelated to sample si0e and items to select.

2,



;. Folloing are seven characteristics that determine competence and an example of each.

$ACTO#DT#%!N!NG CO%*TNC

A%*) O$CO%*TNT V!DNC

&elevance Trace inventory items located in the

arehouse to their inclusion in theinventory su#sidiary records

ndependence of provider !onfirmation of a #ank #alance

7ffectiveness of clients internal controls 4se of duplicate sales invoices for alarge ell-run company

Auditors direct knoledge"hysical examination of inventory #y theauditor

Cualifications of provider etter from an attorney dealing ith theclients affairs

*egree of o#9ectivity !ount of cash on hand #y auditor

Timeliness '#serve inventory on the last day of thefiscal year

-/

T*S O$ A"D!T V!DNC A%*)S

1. "hysical examination !ount petty cash on hand

7xamine fixed asset additions

+. !onfirmation

!onfirm accounts receiva#le #alances of a

sample of client customers !onfirm client$s cash #alance ith #ank

3. *ocumentation 7xamine cancelled checks returned ith cutoff

#ank statement 7xamine vendors$ invoices supporting a

sample of cash dis#ursement transactionsthroughout the year

2. Analytical procedures 7valuate reasona#leness of receiva#les #y

calculating and comparing ratios !ompare expenses as a percentage of net

sales ith prior year$s percentages

2



-/ <continued=

T*S O$ A"D!T V!DNC A%*)S

=. nquiries of the client nquire of management hether there is

o#solete inventory

nquire of management regarding thecollecti#ility of large accounts receiva#le#alances

. &eperformance

D. '#servation

&ecompute invoice total #y multiplying itemprice times quantity sold

Food the sales 9ournal for a one-month periodand compare all totals to the general ledger

'#serve client employees in the process ofcounting inventory

'#serve hether employees are restricted

from access to the check signing machine

-10 The four characteristics of the definition of a confirmation are%

1. &eceipt+. >ritten or oral response3. From independent third party2. &equested #y the auditor

A confirmation is prepared specifically for the auditor and comes from an externalsource. 7xternal documentation is in the hands of the client at the time of the audit and as

prepared for the clients use in the day-to-day operation of the #usiness.

-11 Internal !ocumentation is prepared and used ithin the clients organi0ation ithout ever going to an outside party, such as a customer or vendor.

7xamples% check request form receiving report payroll time card ad9usting 9ournal entry

E$ternal !ocumentation either originated ith an outside party or as an internal

document that ent to an outside party and is no either in the hands of the client or is readilyaccessi#le.

7xamples% vendors invoice cancelled check cancelled note validated deposit slip

2.



-12 Analytical procedures are useful for indicating account #alances that may #e distorted #yunusual or significant transactions and that should #e intensively investigated. They are alsouseful in revieing accounts or transactions for reasona#leness to corro#orate tentativeconclusions reached on the #asis of other evidence.

-13 The most important reasons for performing analytical procedures are the folloing%

1. 4nderstanding the clients industry and #usiness+. Assessment of the entitys a#ility to continue as a going concern3. ndication of the presence of possi#le misstatements in the financial statements2. &eduction of detailed audit tests

-14 The decrease of the current ratio indicates a liquidity pro#lem for 6arper !ompany sincethe ratio has dropped to a level close to the requirements of the #ond indenture. 5pecial careshould #e exercised #y the auditor to determine that the +.B= ratio is proper since managementould #e motivated to hide any loer ratio. The auditor should expand procedures to test allcurrent assets for proper cutoff and possi#le overstatement and to test all current lia#ilities forproper cutoff and possi#le understatement.

-1+ Attention directing analytical procedures occur hen significant, unexpected differencesare found #eteen current years unaudited financial data and other data used in comparisons.f an unusual difference is large, the auditor must determine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or misstatement due tofraud.

>hen an analytical procedure reveals no unusual fluctuations, the implication isminimi0ed. n that case, the analytical procedure constitutes su#stantive evidence in support ofthe fair statement of the related account #alances, and it is possi#le to perform feer detailedsu#stantive tests in connection ith those accounts.

Frequently, the same analytical procedures can #e used for attention directing and forreducing su#stantive tests, depending on the outcome of the tests. 5imple procedures such as

comparing the current year account #alance to the prior year account #alance is more attentiondirecting (and provides less assurance) than more complex analytical procedures< i.e., thosehich rely on regression analysis. ore sophisticated analytical procedures help the auditorexamine relationships #eteen several information varia#les simultaneously. The nature ofthese tests may provide greater assurance than simple procedures.

-1, The statement is correct. 7xcept for certain accounts ith small dollar #alances,analytical procedures are essential to help the auditor identify trends in a clients #usiness andto see the relationship #eteen the clients performance and industry averages. 6oever, theauditor is responsi#le for gathering sufficient competent evidential matter through inspection,o#servation and confirmation in addition to the evidence o#tained as a result of the analyticalprocedures.

2/



-1 The purposes of audit documentation are as follos%

1. To provide a #asis for planning the audit. The auditor may use reference informationfrom the previous year in order to plan this years audit, such as the evaluation ofinternal control, the time #udget, etc.

+. To provide a record of the evidence accumulated and the results of the tests. This is

the primary means of documenting that an adequate audit as performed.3. To provide data for deciding the proper type of audit report. *ata are used in

determining the scope of the audit and the fairness ith hich the financialstatements are stated.

2. To provide a #asis for revie #y supervisors and partners. These individuals use theaudit documentation to evaluate hether sufficient competent evidence asaccumulated to 9ustify the audit report.

Audit documentation are used for several purposes, #oth during the audit and after theaudit is completed. 'ne of the uses is the revie #y more experienced personnel. A second isfor planning the su#sequent year audit. A third is to demonstrate that the auditor hasaccumulated sufficient competent evidence if theres a need to defend the audit at a later date.

For these uses, it is important that the audit documentation provide sufficient information so thatthe person revieing an audit schedule knos the name of the client, contents of the auditschedule, period covered, ho prepared the audit schedule, hen it as prepared, and ho itties into the rest of the audit files ith an index code.

;1. The to criteria used #y auditors of pu#lic companies hen determining hethermemos, correspondence, and other documents must #e maintained in the audit files areas follos%

1. The materials are created, sent, or received in connection ith the audit or revie.+. The materials contain conclusions, opinions, analyses, or financial data related to

the audit or revie.

-1/ The 5ar#anes-'xley Act of +BB+ requires auditors of pu#lic companies to prepare andmaintain audit schedules and other information related to any audit report in sufficient detail tosupport the auditor$s conclusions, for a period of not less than D years.

-20 Audit schedules should include the folloing%

+ame of the client 7na#les the auditor to identify the appropriate file to include the auditschedule in if it is removed from the files.

Perio! covere! 7na#les the auditor to identify the appropriate year to hich an auditschedule for a client #elongs if it is removed from the files.

Descri"tion of the contents A list of the contents ena#les the revieer to determinehether all important parts of the audit schedule have #een included. The contentsdescription is also used as a means of identifying audit files in the same manner that ata#le of contents is used.

Initials of the "re"arer ndicates ho prepared the audit schedule in case there arequestions #y the revieer or someone ho ants information from the files at a later

30



-20 <continued=

date. t also clearly identifies ho is responsi#le for preparing the audit documentation ifthe audit must #e defended.

Date of "re"aration 6elps the revieer to determine the sequence of the preparation of

the audit schedules. t is also useful for the su#sequent year in planning the sequence of preparing audit schedules.

In!e$in 6elps in organi0ing and filing audit schedules. ndexing also facilitates insearching #eteen related portions of the audit documentation.

-21 The permanent file contains data of an historical and continuing nature pertinent to thecurrent audit. 7xamples of items included in the file are%

1. Articles of incorporation+. ylas, #ond indentures, and contracts3. Analysis of accounts that have continuing importance to the auditor

2. nformation related to the understanding of internal control%a. flocharts#. internal control questionnaires

=. &esults of previous years analytical procedures, such as various ratios andpercentages compiled #y the auditors

y separating this information from the current years audit files, it #ecomes easily accessi#lefor the folloing years auditors to o#tain permanent file data.

-22 The purpose of an anal)sis is to sho the activity in a general ledger account during theentire period under audit, tying together the #eginning and ending #alances. The trial balance includes the detailed make-up of an ending #alance. t differs from an analysis in that it includesonly those items comprising the end of the period #alance. A test of reasonableness schedulecontains information that ena#les the auditor to evaluate hether a certain account #alanceappears to #e misstated. 'ne example of a test of reasona#leness schedule is a schedule thatcompares current year expenses to prior years amounts. This type of schedule is intended tosho hich accounts need investigation due to significant variances.

-23 4nansered questions and exceptions may indicate the potential for significant errors orfraud in the financial statements. These should #e investigated and resolved to make sure thatfinancial statements are fairly presented.

The audit files can also #e su#poenaed #y courts as legal evidence. 4nanseredquestions and exceptions may indicate lack of due care #y the auditor.

-24 Tick marks are sym#ols ad9acent to information in audit schedules for the purpose ofindicating the ork performed #y the auditor. An explanation of the tick mark must #e included atthe #ottom of the audit schedule to indicate hat as done and ho did it.

-2+ Audit files are oned #y the auditor. They can #e used #y the client if the auditor antsto release them after a careful consideration of hether there might #e confidential informationin them. The audit files can #e su#poenaed #y a court and there#y #ecome the property of thecourt. They can #e released to another !"A firm ithout the clients permission if they are #eing

31



-2+ <continued=revieed as a part of a voluntary peer revie program under A!"A, state !"A society, or stateoard of Accountancy authori0ation. The audit files can #e sold or released to other users if theauditor o#tains permission from the client.

-2, t is a violation unless the !"A o#tains permission from each client #efore the audit files

for that client are released.

-2 >hen evidence can #e examined only in machine-reada#le form, auditors usecomputers to read and examine evidence. There are commercial audit softare programsdesigned specifically for use #y auditors, such as A! 5oftare and nteractive *ata 7xtractionand Analysis (*7A). 5preadsheet softare packages can also #e used #y auditors to performaudit tests on data that is availa#le only in machine-reada#le form.

-2. The purposes of audit documentation softare are to convert traditional paper-#aseddocumentation into electronic files and to organi0e the audit documentation. The #enefits ofaudit documentation softare, such as Automated !lient 7ngagement (A!7), are as follos%

The auditor can more efficiently prepare a trial #alance, lead schedules, supportingaudit documentation, financial statements, and ratio analysis using the computerrather than #y hand.

The effects of ad9usting 9ournal entries are automatically carried through to the trial#alance and financial statements, making last-minute ad9ustments easier tomake.

Tick marks and revie notes can #e entered directly into computeri0ed files. *ata can #e imported and exported to other applications. For example, a client$s

general ledger can #e donloaded into A!7 and tax information can #edonloaded into a commercial tax preparation package after the audit iscompleted.

Chapter . - Audit *annin5 and Ana7tica *rocedures

.-1 There are three primary #enefits from planning audits% it helps the auditor o#tainsufficient competent evidence for the circumstances, helps keep audit costs reasona#le, andhelps avoid misunderstandings ith the client.

.-2 7ight ma9or steps in planning audits are%

1. Accept client and perform initial planning+. 4nderstand the client$s #usiness and industry3. Assess client #usiness risk

2. "erform preliminary analytical procedures=. 5et materiality, and assess accepta#le audit risk and inherent risk. 4nderstand internal control and assess control riskD. :ather information to assess fraud risks@. *evelop overall audit plan and audit program

32



.-3 The ne auditor (successor) is required #y 5A5 @2 (A4 31=) to communicate ith thepredecessor auditor. This ena#les the successor to o#tain information a#out the client so that heor she may evaluate hether to accept the engagement. "ermission must #e o#tained from theclient #efore communication can #e made #ecause of the confidentiality requirement in the&o!e of Professional &on!uct . The predecessor is required to respond to the successor$srequest for information< hoever, the response may #e limited to stating that no information ill

#e given. The successor auditor should #e ary if the predecessor is reluctant to provideinformation a#out the client.

.-4 "rior to accepting a client, the auditor should investigate the client. The auditor shouldevaluate the client$s standing in the #usiness community, financial sta#ility, and relations ith itsprevious !"A firm. The primary purpose of ne client investigation is to ascertain the integrity of the client and the possi#ility of fraud. The auditor should #e especially concerned ith thepossi#ility of fraudulent financial reporting since it is difficult to uncover. The auditor does notant to needlessly expose himself or herself to the possi#ility of a lasuit for failure to detectsuch fraud.

.-+ An engagement letter is an agreement #eteen the !"A firm and the client concerning

the conduct of the audit and related services. t should state hat services ill #e provided,hether any restrictions ill #e imposed on the auditor$s ork, deadlines for completing theaudit, and assistance to #e provided #y client personnel. The engagement letter may alsoinclude the auditor$s fees. n addition, the engagement letter informs the client that the auditorcannot guarantee that all acts of fraud ill #e discovered.

.;, ecause the 5ar#anes-'xley Act of +BB+ explicitly shifts responsi#ility for hiring andfiring of the auditor from management to the audit committee for pu#lic companies, the auditcommittee is vieed as Gthe clientH in those engagements.

.; All audit and non-audit services must #e preapproved in advance #y the audit committeefor pu#lic companies.

.;. Auditors need an understanding of the client$s #usiness and industry #ecause the natureof the #usiness and industry affect #usiness risk and the risk of material misstatements in thefinancial statements. Auditors use the knoledge of these risks to determine the appropriateextent of audit evidence to accumulate.

The five ma9or aspects of understanding the client$s #usiness and industry, along ithpotential sources of information that auditors commonly use for each of the five areas are asfollos%

1. Industry and External Environment – Read industry trade publications, AICPA Industry Audit

Guides, and regulatory requirements.

2. Business Operations and Processes – Tour te plant and o!!ices, identi!y related parties, and

inquire o! management.

". Management and Governance – Read te corporate carter and byla#s, read minutes o!

board o! directors and stoc$olders, and inquire o! management.

%. Client Objectives and Strategies – Inquire o! management regarding teir ob&ecti'es !or tereliability o! !inancial reporting, e!!ecti'eness and e!!iciency o! operations, and

compliance #it la#s and regulations( read contracts and oter legal documents, suc as

tose !or notes and bonds payable, stoc$ options, and pension plans.

33



.-. continued

). Measurement and Performance – Read !inancial statements, per!orm ratio analysis, and

inquire o! management about $ey per!ormance indicators tat management uses to

measure progress to#ard its ob&ecti'es.

.-/ *uring the course of the plant tour the !"A ill remem#er that an important aspect ofthe audit ill #e an effective analysis of the cost system. Therefore, the auditor ill o#serve thenature of the company$s products, the manufacturing facilities and processes, and the flo ofmaterials so that the information o#tained can later #e related to the functions of the costsystem.

The nature of the company$s products and the manufacturing facilities and processesill reveal the features of the cost system that ill require close audit attention. For example, theaudit of a company engaged in the custom-manufacture of costly products such as yachtsould require attention to the correct charging of material and la#or to specific 9o#s, hereasthe allocation of material and la#or charges in the audit of a #everage-#ottling plant ould not#e verified on the same #asis. The !"A ill note the stages at hich finished products emerge

and here additional materials must #e added. 6e or she ill also #e alert for points at hichscrap is generated or spoilage occurs. The auditor may find it advisa#le, after vieing theoperations, to refer to auditing literature for pro#lems encountered and solved #y other !"As insimilar audits.

The auditor$s o#servation of the manufacturing processes ill reveal hether there isidle plant or machinery that may require disclosure in the financial statements. 5hould themachinery appear to #e old or poorly maintained, the !"A might expect to find heavyexpenditures in the accounts for repairs and maintenance. 'n the other hand, if the auditordetermines that the company has recently installed ne equipment or constructed a ne#uilding, he or she ill expect to find these ne assets on the #ooks.

n studying the flo of materials, the auditor ill #e alert for possi#le pro#lems that mayarise in connection ith the o#servation of the physical inventory, and he or she may makepreliminary estimates of audit staff requirements. n this regard, the auditor ill notice thevarious storage areas and ho the materials are stored. The auditor may also keep in mind forfurther investigation any apparently o#solete inventory.

The auditor$s study of the flo of materials ill disclose the points at hich variousdocuments such as material requisitions arise. 6e or she ill also meet some of the keymanufacturing personnel ho may give the auditor an insight into production pro#lems andother matters such as excess or o#solete materials, and scrap and spoilage. The auditor ill #ealert for the attitude of the manufacturing personnel toard accounting controls. The !"A maymake some inquiries a#out the methods of production scheduling, timekeeping procedures andhether ork standards are employed. As a result of these o#servations, the internaldocuments that relate to the flo of materials ill #e more meaningful as accounting evidence.

The !"A$s tour of the plant ill give him or her an understanding of the plant terminologythat ill ena#le the !"A to communicate fluently ith the client$s personnel. The measurestaken #y the client to safeguard assets, such as protection of inventory from fire or theft, ill #ean indication of the client$s attention to internal control measures. The location of the receivingand shipping departments and the procedures in effect ill #ear upon the !"A$s evaluation ofinternal control. The auditor$s overall impression of the client$s plant ill suggest the accuracyand adequacy of the accounting records that ill #e audited.

34



.-10 'ne type of information the auditor o#tains in gaining knoledge a#out the clients$industry is the nature of the client$s products, including the likelihood of their technologicalo#solescence and future sala#ility. This information is essential in helping the auditor evaluatehether the client$s inventory may #e o#solete or have a market value loer than cost.

.-11 A related party is defined in 5A5 2= (A4 332) as an affiliated company, principal oner

of the client company, or any other party ith hich the client deals here one of the parties caninfluence the management or operating policies of the other.

aterial related party transactions must #e disclosed in the financial statements #ymanagement. Therefore, the auditor must identify related parties and make a reasona#le effortto determine that all material related party transactions have #een properly disclosed in thefinancial statements.

.-12 ecause of the lack of independence #eteen the parties involved, the 5ar#anes-'xley Act prohi#its related party transactions that involve personal loans to executives. t is nounlaful for any pu#lic company to provide personal credit or loans to any director or executiveofficer of the company. anks or other financial institutions are permitted to make normal loansto their directors and officers using market rates, such as residential mortgages.

.-13 n the audit of a client previously audited #y a different !"A firm, it ould #e necessaryto o#tain a copy of the corporate charter and #ylas for the permanent files and to read thesedocuments and prepare a summary a#stract of items to test for compliance. n an ongoingengagement, this ork has #een performed in the past and is unnecessary each year. Theauditor$s responsi#ility is to determine hat changes have #een made during the current yearand to update and revie the summary a#stract prepared in previous years for compliance.

.-14 The information in a mortgage that is likely to #e relevant to the auditor includes thefolloing%

1. The parties to the agreement

+. The effective date of the agreement3. The amounts included in the agreement2. The repayment schedule required #y the agreement=. The definition and terms of default. "repayment options and penalties specified in the agreementD. Assets pledged or encum#ered #y the agreement@. iquidity restrictions imposed #y the agreement?. "urchase restrictions imposed #y the agreement1B. 'perating restrictions imposed #y the agreement11. &equirements for audit reports or other types of reports on compliance ith the

agreement1+. The interest rate specified in the agreement

13. Any other requirements, limitations, or agreements specified in the document

3+



.-1+ nformation in the client$s minutes that is likely to #e relevant to the auditor includes thefolloing%

1. *eclaration of dividends+. Authori0ed compensation of officers3. Acceptance of contracts and agreements2. Authori0ation for the acquisition of property

=. Approval of mergers. Authori0ation of long-term loansD. Approval to pledge securities@. Authori0ation of individuals to sign checks?. &eports on the progress of operations

t is important to read the minutes early in the engagement to identify items that need to #efolloed up on as a part of conducting the audit. For instance, if a long-term loan is authori0edin the minutes, the auditor ill ant to make certain that the loan is recorded as part of long-term lia#ilities.

.-1, The three categories of client o#9ectives are (1) relia#ility of financial reporting, (+)

effectiveness and efficiency of operations, and (3) compliance ith las and regulations. 7achof these o#9ectives affects the auditor$s assessment of inherent risk and evidence accumulationas follos%

1. Reliabilit) of financial re"ortin 2 f management sees the relia#ility of financial reportingas an important o#9ective, and if the auditor can determine that the financial reportingsystem is accurate and relia#le, then the auditor can often reduce inherent risk andplanned evidence accumulation for material accounts. n contrast, if management haslittle regard for the relia#ility of financial reporting, the auditor must increase inherent riskassessments and gather more evidence during the audit.

+. Effectiveness an! efficienc) of o"erations 2 #his area is of "rimar) concern to mostclients1 Au!itors nee! kno'le!e about the effectiveness an! efficienc) of a client3s

o"erations in or!er to assess client business risk an! inherent risk in the financialstatements1 For e$am"le4 if a client is e$"eriencin inventor) manaement "roblems4this 'oul! most likel) increase both the au!itor3s assessment of inherent risk for the

"lanne! evi!ence accumulation for inventor)13. &om"liance 'ith la's an! reulations 2 It is im"ortant for the au!itor to un!erstan! the

la's an! reulations that affect an au!it client4 inclu!in sinificant contracts sine! b)the client1 For e$am"le4 the "rovisions in a "ension "lan !ocument 'oul! sinificantl)affect the au!itor3s assessment of inherent risk an! evi!ence accumulation in the au!it of unfun!e! liabilit) for "ensions1 If the client 'ere in violation of the "rovisions of the

"ension "lan !ocument4 inherent risk an! "lanne! evi!ence for "ension-relate! accounts'oul! increase1

.-1 The purpose of a client$s performance measurement system is to measure the client$sprogress toard specific o#9ectives. "erformance measurement includes ratio analysis and#enchmarking against key competitors.

"erformance measurements for a chain of retail clothing stores could include gross profit#y product line, sales returns as a percentage of clothing sales, and inventory turnover #yproduct line. An nternet portal$s performance measurements might include num#er of >e# sitehits or search engine speed. A hotel chain$s performance measures include vacancypercentages and supply cost per rented room.

3,



.-1. &lient business risk is the risk that the client ill fail to achieve its o#9ectives. 5ources ofclient #usiness risk include any of the factors affecting the client and its environment, includingcompetitor performance, ne technology, industry conditions, and the regulatory environment.The auditor$s primary concern hen evaluating client #usiness risk is the risk of materialmisstatements in the financial statements due to client #usiness risk. For example, if the client$sindustry is experiencing a significant and unexpected donturn, client #usiness risk increases.

This increase ould most likely increase the risk of material misstatements in the financialstatements. The auditor$s assessment of the risk of material misstatements is then used toclassify risks using the audit risk model to determine the appropriate extent of audit evidence.

.-1/ anagement esta#lishes the strategies and #usiness processes folloed #y a client$s#usiness. 'ne top management control is management$s philosophy and operating style,including management$s attitude toard the importance of internal control. 'ther topmanagement controls include a ell-defined organi0ational structure, an effective #oard ofdirectors, and an involved and effective audit committee. f the #oard of directors is effective,this increases management$s a#ility to appropriately respond to risks. An effective auditcommittee can help management reduce the likelihood of overly aggressive accounting.

.-20 Analytical procedures are performed during the planning phase of an engagement toassist the auditor in determining the nature, extent, and timing of ork to #e performed."reliminary analytical procedures also help the auditor identify accounts and classes oftransactions here misstatements are likely. !omparisons that are useful hen performingpreliminary analytical procedures include%

!ompare client and industry data !ompare client data ith similar prior period data !ompare client data ith client-determined expected results !ompare client data ith auditor-determined expected results !ompare client data ith expected results, using nonfinancial data

.-21 Analytical procedures are required during to phases of the audit% (1) during the planningphase to assist the auditor in determining the nature, extent, and timing of ork to #e performedand (+) during the completion phase, as a final revie for material misstatements or financialpro#lems. Analytical procedures are also often done during the testing phase of the audit, #utthey are not required in this phase.

.-22 :ordon could improve the quality of his analytical tests #y%

1. aking internal comparisons to ratios of previous years.+. n cases here the client has more than one #ranch in different industries, computing

the ratios for each #ranch and comparing these to the industry ratios.

.-23 &oger orris performs his ratio and trend analysis at the end of every audit. y thattime, the audit procedures are completed. f the analysis as done at an interim date, the scopeof the audit could #e ad9usted to compensate for the findings. 5A5 = (A4 3+?) requires thatanalytical procedures #e performed in the planning phase of the audit and near the completionof the audit.

The use of ratio and trend analysis appears to give &oger orris an insight into hisclients #usiness and affords him an opportunity to provide excellent #usiness advice to hisclient.

3



.-24 The four categories of financial ratios and examples of ratios in each category are asfollos%

1. *hort-term !ebt-"a)in abilit) I !ash ratio, quick ratio, and current ratio.+. 5i,ui!it) activit) I Accounts receiva#le turnover, days to collect receiva#les,

inventory turnover, and days to sell inventory.

3. Abilit) to meet lon-term !ebt obliations I *e#t to equity and times interestearned.

2. Profitabilit) 2 7arnings per share, gross profit percent, profit margin, return onassets, and return on common equity

Chapter / - %ateriait7 and #is>

/-1 The planning phases are% accept client and perform initial planning, understand theclient$s #usiness and industry, assess client #usiness risk, perform preliminary analyticalprocedures, set materiality and assess accepta#le audit risk and inherent risk, understandinternal control and assess control risk, gather information to assess fraud risk, and develop

overall audit plan and audit program. 7valuation of materiality is part of phase five. &iskassessment is part of phase three (client #usiness risk), phase five (accepta#le audit risk andinherent risk), phase six (control risk), and phase seven (fraud risk).

/-2 ateriality is defined as% the magnitude of an omission or misstatement of accountinginformation that, in light of the surrounding circumstances, makes it pro#a#le that the 9udgmentof a reasona#le person relying on the information ould have #een changed or influenced #ythe omission or misstatement.

E'#tain reasona#le assurance,E as used in the audit report, means that the auditor doesnot uarantee or insure the fair presentation of the financial statements. There is some risk thatthe financial statements contain a material misstatement.

/-3 ateriality is important #ecause if financial statements are materially misstated, usersdecisions may #e affected, and there#y cause financial loss to them. t is difficult to apply#ecause there are often many different users of the financial statements. The auditor musttherefore make an assessment of the likely users and the decisions they ill make. ateriality isalso difficult to apply #ecause it is a relative concept. The professional auditing standards offerlittle specific guidance regarding the application of materiality. The auditor must, therefore,exercise considera#le professional 9udgment in the application of materiality.

/-4 The preliminary 9udgment a#out materiality is the maximum amount #y hich the auditor#elieves the financial statements could #e misstated and still not affect the decisions ofreasona#le users. 5everal factors affect the preliminary 9udgment a#out materiality and are asfollos%

1. ateriality is a relative rather than an a#solute concept.+. ases are needed for evaluating materiality.3. Cualitative factors affect materiality decisions.2. 7xpected distri#ution of the financial statements ill affect the preliminary

9udgment of materiality. f the financial statements are idely distri#uted to users,the preliminary 9udgment of materiality ill pro#a#ly #e set loer than if thefinancial statements are not expected to #e idely distri#uted.

=. The level of accepta#le audit risk ill also affect the preliminary 9udgment ofmateriality.

3.



/-+ ecause materiality is relative rather than a#solute, it is necessary to have #ases foresta#lishing hether misstatements are material. For example, in the audit of a manufacturingcompany, the auditor might use as #ases% net income #efore taxes, total assets, current assets,and orking capital. For a governmental unit, such as a school district, there is no net income#efore taxes, and therefore that ould #e an unavaila#le #ase. nstead, the primary #asesould likely #e fund #alances, total assets, and perhaps total revenue.

/-, The folloing qualitative factors are likely to #e considered in evaluating materiality%

a. Amounts involving fraud are usually considered more important thanunintentional errors of equal dollar amounts.

#. isstatements that are otherise minor may #e material if there are possi#leconsequences arising from contractual o#ligations.

c. isstatements that are otherise immaterial may #e material if they affect atrend in earnings.

/- A preliminary 9udgment a#out materiality is set for the financial statements as a hole.Tolera#le misstatement is the maximum amount of misstatement that ould #e considered

material for an individual account #alance. The amount of tolera#le misstatement for any givenaccount is dependent upon the preliminary 9udgment a#out materiality. 'rdinarily, tolera#lemisstatement for any given account ould have to #e loer than the preliminary 9udgment a#outmateriality. n many cases, it ill #e considera#ly loer #ecause of the possi#ility ofmisstatements in different accounts that, in total, cannot exceed the preliminary 9udgment a#outmateriality.

/-. There are several possi#le ansers to the question. 'ne example is%

!ash L=BB 'verstatementFixed assets L3,BBB 'verstatementong-term loans L1,=BB 4nderstatement

Note% !ash and fixed assets are tested for overstatement and long-term loans forunderstatement #ecause the auditors o#9ective in this case is to test for overstatementsof oners equity.

The least amount of tolera#le misstatement as allocated to cash and long-term loans#ecause they are relatively easy to audit. The ma9ority of the total allocation as to fixed assets#ecause there is a greater likelihood of misstatement of fixed assets in a typical audit.

/-/ An estimate of the total misstatement in a segment is the estimate of the totalmisstatements #ased upon the sample results. f only a sample of the population is selected andaudited, the auditor must pro9ect the total sample misstatements to a total estimate. This is done

audit area #y audit area. The misstatements in each audit area must #e totaled to make anestimate of the total misstatements in the overall financial statements. t is important to makethese estimates so the auditor can evaluate hether the financial statements, taken as a hole,may #e materially misstated. The estimate for each segment is compared to tolera#lemisstatement for that segment and the estimate of the overall misstatement on the financialstatements is compared to the preliminary 9udgment a#out materiality.

3/



/-10 f an audit is #eing performed on a medium-si0ed company that is part of aconglomerate, the auditor must make a materiality 9udgment #ased upon the conglomerate.ateriality may #e larger for a company that is part of a conglomerate #ecause even though thefinancial statements of the medium-si0ed company may #e misstated, the financial statementsof the large conglomerate might still #e fairly stated. f, hoever, the auditor is giving a separateopinion on the medium-si0ed company, the materiality ould #e loer than for the audit of a

conglomerate.

/-11 The audit risk model is as follos%

PDR M AARIR x &R

>here PDR M "lanned detection risk AAR M Accepta#le audit riskIR M nherent risk&R M !ontrol risk

Planne! !etection risk A measure of the risk that audit evidence for a segmentill fail to detect misstatements exceeding a tolera#le amount, should suchmisstatements exist.

Acce"table au!it risk A measure of ho illing the auditor is to accept that thefinancial statements may #e materially misstated after the audit is completed andan unqualified opinion has #een issued.

Inherent risk A measure of the auditors assessment of the likelihood that thereare material misstatements in a segment #efore considering the effectiveness ofinternal control.

&ontrol risk A measure of the auditors assessment of the likelihood thatmisstatements exceeding a tolera#le amount in a segment ill not #e preventedor detected #y the clients internal controls.

/-12 "lanned detection risk is a measure of the risk that the audit evidence for a segment illfail to detect misstatements exceeding a tolera#le amount, should such misstatements exist.>hen planned detection risk is increased from medium to high, the amount of evidence theauditor must accumulate is reduced.

/-13 An increase in planned detection risk may #e caused #y an increase in accepta#le auditrisk or a decrease in either control risk or inherent risk. A decrease in planned detection risk iscaused #y the opposite% a decrease in accepta#le audit risk or an increase in control risk or

inherent risk.

40



/-14 nherent risk is a measure of the auditors assessment of the likelihood that there arematerial misstatements in a segment #efore considering the effectiveness of internal control.

Factors affecting assessment of inherent risk include%

ature of the clients #usiness &esults of previous audits nitial vs. repeat engagement &elated parties onroutine transactions 8udgment required to correctly record transactions and akeup of the population

/-1+ nherent risk is set for segments rather than for the overall audit #ecause misstatementsoccur in segments. y identifying expectations of misstatements in segments, the auditor isthere#y a#le to modify audit evidence #y searching for misstatements in those segments.

>hen inherent risk is increased from medium to high, the auditor should increase theaudit evidence accumulated to determine hether the expected misstatement actually occurs.The audit evidence goes in the opposite direction in &evie Cuestion ?-1+.

/-1, 7xtensive misstatements in the prior years audit ould cause inherent risk to #e set at ahigh level (may#e even 1BBN). An increase in inherent risk ould lead to a decrease in planneddetection risk, hich ould require that the auditor increase the level of planned audit evidence.

/-1 Accepta#le audit risk is a measure of ho illing the auditor is to accept that thefinancial statements may #e materially misstated after the audit is completed and an unqualifiedopinion has #een issued.

Accepta#le audit risk has an inverse relationship to evidence. f accepta#le audit risk isreduced, planned evidence should increase.

/-1. >hen the auditor is in a situation here he or she #elieves that there is a high exposure

to legal lia#ility, the accepta#le audit risk ould #e set loer than hen there is little exposure tolia#ility. 7ven hen the auditor #elieves that there is little exposure to legal lia#ility, there is still aminimum accepta#le audit risk that should #e met.

/-1/ The first category of factors that determine accepta#le audit risk is the degree to hichusers rely on the financial statements. The folloing factors are indicators of this%

!lients si0e *istri#ution of onership ature and amount of lia#ilities

The second category of factors is the likelihood that a client ill have financial difficulties

after the audit report is issued. Factors affecting this are%

iquidity position "rofits (losses) in previous years ethod of financing groth ature of the clients operations !ompetence of management

41



/-1/ continued

The third category of factors is the auditors evaluation of managements integrity.Factors that may affect this are%

&elationship ith current or previous auditors Frequency of turnover of key financial or internal audit personnel &elationship ith employees and la#or unions

/-20 7xact quantification of all components of the audit risk model is not required to use themodel in a meaningful ay. An understanding of the relationships among model componentsand the effect that changes in the components have on the amount of evidence needed illallo practitioners to use the audit risk model in a meaningful ay.

/-21 The auditor should revise the components of the audit risk model hen the evidenceaccumulated during the audit indicates that the auditors original assessments of inherent risk or control risk are too lo or too high or the original assessment of accepta#le audit risk is too loor too high.

The auditor should exercise care in determining the additional amount of evidence thatill #e required. This should #e done ithout the use of the audit risk model. f the audit riskmodel is used to determine a revised planned detection risk, there is a danger of not increasingthe evidence sufficiently.

Chapter 10 - Section 404 Audits of !nterna Contro and Contro #is>

10-1 anagement typically has three #road o#9ectives in designing an effective internalcontrol system.

1; #eia6iit7 of $inancia #eportin5 anagement is responsi#le for preparing financialstatements for investors, creditors, and other users. anagement has #oth a legal andprofessional responsi#ility to #e sure that the information is fairly presented in accordanceith reporting requirements such as :AA". The o#9ective of effective internal control overfinancial reporting is to fulfill these financial reporting responsi#ilities.

2; fficienc7 and ffectiveness of Operations !ontrols ithin an organi0ation aremeant to encourage efficient and effective use of its resources to optimi0e the company$sgoals. An important o#9ective of these controls is accurate financial and non-financialinformation a#out the entity$s operations for decision making.

3; Compiance ?ith )a?s and #e5uations 5ection 2B2 of the 5ar#anes-'xley Actrequires all pu#lic companies to issue a report a#out the operating effectiveness of internalcontrol over financial reporting. n addition to the legal provisions of 5ection 2B2, pu#lic,nonpu#lic, and not-for-profit organi0ations are required to follo many las and regulations.5ome relate to accounting only indirectly, such as environmental protection and civil rightslas. 'thers are closely related to accounting, such as income tax regulations and fraud.

42



10-2 anagement designs systems of internal control to accomplish three categories ofo#9ectives% financial reporting, operations, and compliance ith las and regulations. Theauditor$s focus in #oth the audit of financial statements and the audit of internal controls is onthose controls related to the relia#ility of financial reporting plus those controls related tooperations and to compliance ith las and regulations o#9ectives that could materially affectfinancial reporting.

10-3 5ection 2B2 requires management of all pu#lic companies to issue an internal controlreport that includes the folloing% A statement that management is responsi#le for esta#lishing and maintaining an adequate

internal control structure and procedures for financial reporting and An assessment of the effectiveness of the internal control structure and procedures for

financial reporting as of the end of the company$s fiscal year.

10-4 anagement$s assessment of internal control over financial reporting consists of to keycomponents. First, management must evaluate the !esin of internal control over financialreporting. 5econd, management must test the o"eratin effectiveness of those controls. >henevaluating the design of internal control over financial reporting, management evaluateshether the controls are designed to prevent or detect material misstatements in the financialstatements. >hen testing the operating effectiveness of those controls, the o#9ective is todetermine hether the control is operating as designed and hether the person performing thecontrol possesses the necessary authority and qualifications to perform the control effectively.

10-+ There are eight parts of the planning phase of audits% accept client and perform initialplanning, understand the client$s #usiness and industry, assess client #usiness risk, performpreliminary analytical procedures, set materiality and assess accepta#le audit risk and inherentrisk, understand internal control and assess control risk, gather information to assess fraud risk,and develop an overall audit plan and audit program. 4nderstanding internal control andassessing control risk is therefore part six of planning. 'nly gathering information to assessfraud risk and developing an overall audit plan and audit program follo understanding internal

control and assessing control risk.

10-, The second :AA5 field ork standard states GA sufficient understanding of internalcontrol is to #e o#tained to plan the audit and to determine the nature, timing, and extent of teststo #e performed.H The auditor o#tains the understanding of internal control to assess control riskin every audit and that responsi#ility is the same for audits of #oth pu#lic and nonpu#liccompanies. Auditors are primarily concerned a#out controls related to the relia#ility of financialreporting and controls over classes of transactions.

10- 5ection 2B2 requires that the auditor attest to and issue a report on management$sassessment of internal control over financial reporting. To express an opinion on internalcontrols, the auditor o#tains an understanding of and performs tests of controls related to all

significant account #alances, classes of transactions, and disclosures and related assertions inthe financial statements. "!A' 5tandard + requires that the audit report on internal controlover financial reporting under 5ar#anes-'xley include the auditor$s opinion as to hethermanagement$s assessment of the design and operating effectiveness of internal control overfinancial reporting is fairly stated in all material respects. This involves #oth evaluatingmanagement$s assessment process and arriving at the auditor$s independent assessment of theinternal controls$ design and operating effectiveness.

43



10-. The six transaction-related audit o#9ectives are%

1. &ecorded transactions exist (existence).+. 7xisting transactions are recorded (completeness).3. &ecorded transactions are stated at the correct amounts (accuracy).2. Transactions are properly classified (classification).

=. Transactions are recorded on the correct dates (timing).. &ecorded transactions are properly included in the master files and correctly

summari0ed (posting and summari0ation).

10-/ !'5'$s Internal &ontrol − Interate! Frame'ork is the most idely accepted internalcontrol frameork in the 4.5. The !'5' frameork descri#es internal control as consisting offive components that management designs and implements to provide reasona#le assurancethat its control o#9ectives ill #e met. 7ach component contains many controls, #ut auditorsconcentrate on those designed to prevent or detect material misstatements in the financialstatements.

10-10 The !'5' Internal &ontrol 2 Interate! Frame'ork consists of the folloing five

components%

1. !ontrol environment+. &isk assessment3. !ontrol activities2. nformation and communication=. onitoring

The control environment serves as the um#rella for the other four components. >ithout aneffective control environment, the other four are unlikely to result in effective internal control,regardless of their quality.

10-11 The control environment consists of the actions, policies, and procedures that reflect theoverall attitudes of top management, directors, and oners of an entity a#out internal controland its importance to the entity. The folloing are the most important su#components thecontrol environment%

ntegrity and ethical values !ommitment to competence oard of directors or audit committee participation anagements philosophy and operating style 'rgani0ational structure Assignment of authority and responsi#ility 6uman resource policies and practices

44



10-12 nternal control includes five categories of controls that management designs andimplements to provide reasona#le assurance that its control o#9ectives ill #e met. These arecalled the components internal control, and are%

The control environment &isk assessment !ontrol activities nformation and communication onitoring

The control environment is the #roadest of the five and deals primarily ith the aymanagement implements its attitude a#out internal controls. The other four components areclosely related to the control environment. &isk assessment is managements identification andanalysis of risks relevant to the preparation of financial statements in accordance ith :AA". Torespond to this risk assessment, management implements control activities and creates theaccounting information and communication system to meet its o#9ectives for financial reporting.Finally, management periodically assesses the quality of internal control performance todetermine that controls are operating as intended and that they are modified as appropriate for

changes in conditions (monitoring).

10-13 The five categories of control activities are%

Adequate separation of duties*+ample Te !ollo#ing t#o !unctions are per!ormed by di!!erent people

processing customer orders and billing o! customers.

"roper authori0ation of transactions and activities7xample% The granting of credit is authori0ed #efore shipment takesplace.

Adequate documents and records7xample% &ecording of sales is supported #y authori0ed shippingdocuments and approved customer orders.

"hysical control over assets and records7xample% A passord is required #efore entry into the computeri0edaccounts receiva#le master file can #e made.

ndependent checks on performance*+ample Accounts recei'able master !ile contents are independently 'eri!ied.

10-14 5eparation of operational responsi#ility from record keeping is intended to reduce thelikelihood of operational personnel #iasing the results of their performance #y incorrectlyrecording information.

5eparation of the custody of assets from accounting for these assets is intended to

prevent misappropriation of assets. >hen one person performs #oth functions, the possi#ility ofthat persons disposal of the asset for personal gain and ad9ustment of the records to relievehimself or herself of responsi#ility for the asset ithout detection increases.

4+



10-1+ An example of a physical control the client can use to protect each of the folloingassets or records is%

1. "etty cash should #e kept locked in a fireproof safe.+. !ash received #y retail clerks should #e entered into a cash register to record all

cash received.

3. Accounts receiva#le records should #e stored in a locked, fireproof safe. Adequate #ackup copies of computeri0ed records should #e maintained andaccess to the master files should #e restricted via passords.

2. &a material inventory should #e retained in a locked storeroom ith a relia#leand competent employee controlling access.

=. "erisha#le tools should #e stored in a locked storeroom under control of arelia#le employee.

. anufacturing equipment should #e kept in an area protected #y #urglar alarmsand fire alarms and kept locked hen not in use.

D. arketa#le securities should #e stored in a safety deposit vault.

10-1, ndependent checks on performance are internal control activities designed for the

continuous internal verification of other controls. 7xamples of independent checks include%

"reparation of the monthly #ank reconciliation #y an individual ith noresponsi#ility for recording transactions or handling cash.

&ecomputing inventory extensions for a listing of inventory #y someone ho didnot originally do the extensions.

The preparation of the sales 9ournal #y one person and the accounts receiva#lemaster file #y a different person, and a reconciliation of the control account to themaster file.

The counting of inventory #y to different count teams. The existence of an effective internal audit staff.

10-1 As illustrated #y Figure 1B-3, there are four phases in the process of understandinginternal control and assessing control risk. n the first phase the auditor o#tains anunderstanding of internal controls. ext the auditor must make a preliminary assessment controlrisk (phase +) and perform tests of controls in every audit as part of their integrated audits(phase 3). The auditor uses the results of tests of controls for #oth the audit report on internalcontrol over financial reporting and to assess control risk and to ultimately decide planneddetection risk and su#stantive tests for the audit of financial statements, hich is phase 2.

10-1. 5ection 2B2 of the 5ar#anes-'xley Act requires management to document its processesfor assessing the effectiveness of the company$s internal control over financial reporting.anagement must document the design of controls, including all five control components andalso the results of its testing and evaluation. The types of information gathered #y management

to assess and document internal control effectiveness can take many forms, including policymanuals, flocharts, narratives, documents, questionnaires and other forms that are in eitherpaper or electronic formats. "!A' 5tandard + requires the auditor to evaluate the client$sdocumentation hen auditing internal control over financial reporting. The lack of managementdocumentation of internal control over financial reporting may prevent the auditor fromconcluding that the controls are adequately designed or operating effectively. >hendocumentation is inadequate, the auditor may decide to ithdra from the engagement or toissue a disclaimer of opinion on internal control over financial reporting.

4,



10-1/ >hen o#taining an understanding of internal control, the auditor must assess toaspects a#out those controls. First, the auditor must gather evidence a#out the !esin ofinternal controls. 5econd, the auditor must gather evidence a#out hether those controls have#een "lace! in o"eration.

10-20 n a alkthrough of internal control, the auditor selects one or a fe documents for the

initiation of a transaction type and traces them through the entire accounting process. At eachstage of processing, the auditor makes inquiries and o#serves current activities, in addition toexamining completed documentation for the transaction or transactions selected. Thus, theauditor com#ines o#servation, documentation, and inquiry to conduct a alkthrough of internalcontrol. "!A' 5tandard + requires the auditor to perform at least one alkthrough for eachma9or class of transactions.

10-21 A key control is a control that is expected to have the greatest effect on meeting thetransaction-related audit o#9ectives. A control deficiency represents a deficiency in the design oroperation of controls that does not permit company personnel to prevent or detectmisstatements on a timely #asis. A !esin !eficienc) exists if a necessary control is missing ornot properly designed. An o"eration !eficienc) exists if a ell designed control does not operate

as designed or hen the person performing the control is insufficiently qualified or authori0ed.

10-22 A significant deficiency exists if one or more control deficiencies exist that, more thanremotel) adversely affect a company$s a#ility to initiate, authori0e, record, process, or reportexternal financial statements relia#ly. A material eakness exists if a significant deficiency, #yitself, or in com#ination ith other significant deficiencies, results in a more than remotelikelihood that internal control ill not prevent or detect material financial statementmisstatements. The presence of one significant deficiency that is not deemed to #e a materialeakness may not affect the auditor$s report. n that instance, the auditor$s report on internalcontrol over financial reporting ould contain an unqualified opinion. 6oever, if the deficiencyis deemed to #e a material eakness, the auditor must express an adverse opinion on theeffectiveness of internal control over financial reporting.

10-23 The most important internal control deficiency hich permitted the defalcation to occuras the failure to adequately segregate the accounting responsi#ility of recording #illings in thesales 9ournal from the custodial responsi#ility of receiving the cash. &egardless of hotrustorthy 8ames appeared, no employee should #e given the com#ined duties of custody ofassets and accounting for those assets.

10-24 aier is correct in her #elief that internal controls frequently do not function in themanner they are supposed to. 6oever, regardless of this, her approach ignores the value of#eginning the understanding of internal control #y preparing or revieing a rough flochart.'#taining an early understanding of the clients internal control ill provide aier ith a #asisfor a decision a#out the audit procedures and sample si0es #ased on assessed control risk. ynot o#taining an understanding of internal control until later in the engagement, aier risks

performing either too much or too little ork, or emphasi0ing the rong areas during her audit.

4



10-2+ The extent of controls tested #y auditors to express an opinion on internal controls for apu#lic company is significantly greater than that tested solely to express an opinion on thefinancial statements. To express an opinion on internal controls for a pu#lic company, the auditor o#tains an understanding of and performs tests of controls for all significant account #alances,classes of transactions, and disclosures and related assertions in the financial statements. ncontrast, the extent of controls tested #y an auditor of a nonpu#lic company is dependent on the

auditor$s assessment of control risk. >henever the auditor assesses control risk #elomaximum, the auditor must perform tests of controls to support that control risk assessment.The auditor 'ill not "erform tests of controls hen the auditor assesses control risk atmaximum, either #ecause of inadequate controls or #ecause it is inefficient to test thosecontrols. >hen control risk is assessed #elo the maximum, the auditor designs and performs acom#ination of tests of controls and su#stantive procedures. Thus, for a nonpu#lic company, thetests of controls vary #ased on the auditor$s assessment of control risk.

10-2, There is a significant overlap #eteen tests of controls and procedures to o#tain anunderstanding of internal control. oth include inquiry, documentation, and o#servation. Thereare to primary differences in the application of these common procedures. First, in o#tainingan understanding of internal control, the procedures to o#tain an understanding are applied toall controls identified during that phase. Tests of controls, on the other hand, are applied only

hen the assessed control risk has not #een satisfied #y the procedures to o#tain anunderstanding. 5econd, procedures to o#tain an understanding are performed only on one or afe transactions or, in the case of o#servations, at a single point in time. Tests of controls areperformed on larger samples of transactions (perhaps +B to 1BB), and often o#servations aremade at more than one point in time.

10-2 "!A' 5tandard + requires a pu#lic company auditor to test controls each year for allrelevant assertions for significant accounts and transactions. 6oever, if evidence as o#tainedin the prior year$s audit that indicates that a key control as operating effectively, and theauditor determines that the control is still in place, the extent of the tests of that control may #ereduced somehat in the current year.

10-2. "!A' 5tandard + requires that the auditor$s report on internal control include toauditor opinions%

1. The auditor$s opinion on hether management$s assessment of the effectiveness ofinternal control over financial reporting as of the end of the fiscal period is fairly stated, inall material respects. n practice it is unlikely for the auditor to issue anything other thanan unqualified report on this opinion. f the auditor concludes that management has notidentified and reported all significant deficiencies and material eaknesses, it ill #e inmanagement$s #est interests to revise its report to conform to the auditor$s conclusions.

+. The auditor$s opinion on hether the company maintained, in all material respects,effective internal control over financial reporting as of the specified date. There is likely to#e more variety in these reports.

4.



10;2/ The auditor may issue an unqualified opinion on internal control over financial reportinghen to conditions are present%

there are no identified material eaknesses< and there have #een no restrictions on the scope of the auditor$s ork.

A scope limitation is the condition that ould cause the auditor to express a ,ualifie! o"inion ora !isclaimer of o"inion on internal control over financial reporting. This type of opinion is issuedhen the auditor is una#le to determine if there are material eaknesses, due to a restriction onthe scope of the audit of internal control over financial reporting or other circumstances herethe auditor is una#le to o#tain sufficient evidence.

10-30 "!A' 5tandard + requires that the audit of the financial statements and the audit ofinternal control over financial reporting #e integrated. n an integrated audit, the auditor mustconsider the results of audit procedures performed to issue the audit report on the financialstatements hen issuing the audit report on internal control. For example, if the auditoridentifies a material misstatement in the financial statements that as not initially identified #ythe company$s internal controls, the auditor should consider this as at least a significant

deficiency, if not a material eakness for purposes of reporting on internal control. n suchcircumstances, the auditor$s report on the financial statements may #e unqualified as long asmanagement corrected the misstatement #efore issuing the financial statements. n contrast,hoever, the auditor$s report on internal control must include an adverse opinion if the auditorconcludes it is a material eakness.

Chapter 11 - $raud Auditin5

11-1 Fraudulent financial reporting is an intentional misstatement or omission of amounts ordisclosures ith the intent to deceive users. To examples of fraudulent financial reporting areaccelerating the timing of recording sales revenue to increased reported sales and earnings,and recording expenses as fixed assets to increase earnings.

11-2 isappropriation of assets is fraud that involves theft of an entity$s assets. To examplesare an accounts paya#le clerk issuing payments to a fictitious company controlled #y the clerk,and a sales clerk failing to record a sale and pocketing the cash receipts.

11-3 Fraudulent financial reporting is an intentional misstatement or omission of amounts ordisclosures ith the intent to deceive users, hile misappropriation of assets is fraud thatinvolves theft of an entity$s assets. Frauds involving financial reporting are usually larger thanfrauds involving misappropriation of assets, usually involve top management, and do not directlyinvolve theft of company assets.

4/



11-4 The three conditions of fraud referred to as the Gfraud triangleH are (1)ncentivesO"ressures< (+) 'pportunities< and (3) AttitudesO&ationali0ation. ncentivesO"ressuresare incentives of management or other employees to commit fraud. 'pportunities arecircumstances that allo management or employees to commit fraud. AttitudesO&ationali0ationare indications that an attitude, character, or set of ethical values exist that allo managementor employees to commit a dishonest act or they are in an environment that imposes sufficient

pressure that causes them to rationali0e committing a dishonest act.

11;+ The folloing are example of risk factors for fraudulent financial reporting for each of thethree fraud conditions%

Incentives6Pressures - The company is under pressure to meet de#t covenantsor o#tain additional financing.

O""ortunities I neffective oversight of financial reporting #y the #oard ofdirectors allos management to exercise discretion over reporting.

Attitu!es6Rationali%ation I anagement is overly aggressive. For example, thecompany may issue aggressive earnings forecasts, or make extensiveacquisitions using company stock.

11;, The folloing are example of risk factors for misappropriation of assets for each of thethree fraud conditions%

Incentives6Pressures - The individual is una#le to meet personal financialo#ligations.

O""ortunities I There is insufficient segregation of duties that allos theindividual to handle cash receipts and related accounting records.

Attitu!es6Rationali%ation I anagement has disregarded the inadequateseparation of duties that allos the potential theft of cash receipts.

11; Auditors use several sources to gather information a#out fraud risks, including%

nformation o#tained from communications among audit team mem#ers a#outtheir knoledge of the company and its industry, including ho and here thecompany might #e suscepti#le to material misstatements due to fraud.

&esponses to auditor inquiries of management a#out their vies of the risks offraud and a#out existing programs and controls to address specific identifiedfraud risks.

5pecific risk factors for fraudulent financial reporting and misappropriations ofassets.

Analytical procedures results o#tained during planning that indicate possi#leimplausi#le or unexpected analytical relationships.

Jnoledge o#tained through other procedures such as client acceptance andretention decisions, interim revie of financial statements, and consideration ofinherent or control risks.

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11-. 5A5 ?? requires the audit team to conduct discussions to share insights from moreexperienced audit team mem#ers and to G#rainstormH ideas that address the folloing%

1. 6o and here they #elieve the entity$s financial statements might #esuscepti#le to material misstatement due to fraud. This should includeconsideration of knon external and internal factors affecting the entity that might

create an incentive or pressure for management to commit fraud. provide the opportunity for fraud to #e perpetrated. indicate a culture or environment that ena#les management to rationali0e

fraudulent acts.+. 6o management could perpetrate and conceal fraudulent financial reporting.3. 6o assets of the entity could #e misappropriated.2. 6o the auditor might respond to the suscepti#ility of material misstatements due

to fraud.

11-/ Auditors must inquire hether management has knoledge of any fraud or suspectedfraud ithin the company. 5A5 ?? also requires auditors to inquire of the audit committee a#outits vies of the risks of fraud and hether the audit committee has knoledge of any fraud or

suspected fraud. f the entity has an internal audit function, the auditor should inquire a#outinternal audit$s vies of fraud risks and hether they have performed any procedures to identifyor detect fraud during the year. 5A5 ?? further requires the auditor to make inquiries of othersithin the entity hose duties lie outside the normal financial reporting lines of responsi#ilitya#out the existence or suspicion of fraud.

11-10 The corporate code of conduct esta#lishes the Gtone at the topH of the importance ofhonesty and integrity and can also provide more specific guidance a#out permitted andprohi#ited #ehavior. 7xample of items typically addressed in a code of conduct includeexpectations of general employee conduct, restrictions on conflicts of interest, and limitations onrelationships ith clients and suppliers.

11-11 anagement and the #oard of directors are responsi#le for setting the Gtone at the topHfor ethical #ehavior in the company. t is important for management to #ehave ith honesty andintegrity #ecause this reinforces the importance of these values to employees throughout theorgani0ation.

11-12 anagement has primary responsi#ility to design and implement antifraud programs andcontrols to prevent, deter, and detect fraud. The audit committee has primary responsi#ility tooversee the organi0ation$s financial reporting and internal control processes and to provideoversight of management$s fraud risk assessment process and antifraud programs and controls.

11-13 The three auditor responses to fraud are% (1) change the overall conduct of the audit to

respond to identified fraud risks< (+) design and perform audit procedures to address identifiedrisks< and (3) perform procedures to address the risk of management override of controls.

11-14 Auditors are required to take three actions to address potential management override ofcontrols% (1) examine 9ournal entries and other ad9ustments for evidence of possi#lemisstatements due to fraud< (+) revie accounting estimates for #iases< and (3) evaluate the#usiness rationale for significant unusual transactions.

+1



11-1+ Three main techniques use to manipulate revenue include% (1) recording of fictitiousrevenue< (+) premature revenue recognition including techniques such as #ill-and-hold salesand channel stuffing< and (3) manipulation of ad9ustments to revenue such as sales returns andalloance and other contra accounts.

11-1, !ash register receipts are particularly suscepti#le to theft. The notice Gyour meal is free if

e fail to give you a receiptH is designed to ensure that every customer is given a receipt and allsales are entered into the register, esta#lish accounta#ility for the sale.

11-1 The three types of inquiry are informational, assessment, and interrogative. Auditors useinformational inquiry to o#tain information a#out facts and details that the auditor does not have.For example, if the auditor suspects financial statement fraud involving improper revenuerecognition, the auditor may inquire of management as to revenue recognition policies. Theauditor uses assessment inquiry to corro#orate or contradict prior information. n the previousexample, the auditor may attempt to corro#orate the information o#tained from management #ymaking assessment inquiries of individuals in accounts receiva#le and shipping. nterrogativeinquiry is used to determine if the intervieee is #eing deceptive or purposefully omittingdisclosure of key knoledge of facts, events, or circumstances. For example, a senior mem#er

of the audit team might make interrogative inquiries of management or other personnel a#outkey elements of the fraud here earlier responses ere contradictory or evasive.

11-1. >hen making inquiries of a deceitful individual, three examples of ver#al cues arefrequent rephrasing of the question, filler terms such as GellH or Gto tell the truth,H andforgetfulness or acknoledgements of nervousness. Three examples of nonver#al cues #y theindividual are creating physical #arriers #y #locking their mouth, leaning aay from the auditor,and signs of stress such as seating or fidgeting.

11-1/ >hen the auditor suspects that fraud may #e present, 5A5 ?? requires the auditor too#tain additional evidence to determine hether material fraud has occurred. 5A5 ?? alsorequires the auditor to consider the implications for other aspects of the audit. >hen the auditor

determines that fraud may #e present, 5A5 ?? requires the auditor to discuss the matter andaudit approach for further investigation ith an appropriate level of management that is at leastone level a#ove those involved, and ith senior management and the audit committee, even ifthe matter might #e considered inconsequential. For pu#lic company auditors, the discovery offraud of any magnitude #y senior management is at least a significant deficiency and may #e amaterial eakness in internal control over financial reporting. This includes fraud #y seniormanagement that results in even immaterial misstatements. f the pu#lic company auditordecides the fraud is a material eakness, the auditor$s report on internal control over financialreporting ill contain an adverse opinion.

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Chapter 12 - The !mpact of !nformation Technoo57 on the Audit*rocess

12-1 The proper installation of T can lead to internal control enhancements #y replacingmanually-performed controls ith computer-performed controls. T-#ased accounting systems

have the a#ility to handle tremendous volumes of complex #usiness transactions costeffectively. !omputer-performed controls can reduce the potential for human error #y replacingmanual controls ith programmed controls that apply checks and #alances to each transactionprocessed. The systematic nature of T offers greater potential to reduce the risk of materialmisstatements resulting from random, human errors in processing.

The use of T #ased accounting systems also offers the potential for improvedmanagement decisions #y providing more and higher quality information on a more timely #asisthan traditional manual systems. T-#ased systems are usually administered effectively #ecausethe complexity requires effective organi0ation, procedures, and documentation. That in turnenhances internal control.

12-2 >hen entities rely heavily on T systems to process financial information, there are ne

risks specific to T environments that must #e considered. Jey risks include the folloing%

Reliance on the functionin ca"abilities of har!'are an! soft'are1 The risk ofsystem crashes due to hardare or softare failures must #e evaluated henentities rely on T to produce financial statement information.

7isibilit) of au!it trail . The use of T often converts the traditional paper trail to anelectronic audit trail, eliminating source documents and paper-#ased 9ournals andrecords.

Re!uce! human involvement1 The replacement of traditional manual processesith computer-performed processes reduces opportunities for employees torecogni0e misstatements resulting from transactions that might have appearedunusual to experienced employees.

*)stematic versus ran!om errors1 *ue to the uniformity of processing performed

#y T #ased systems, errors in computer softare can result in incorrectprocessing for all transactions processed. This increases the risk of manysignificant misstatements.

8nauthori%e! access1 The centrali0ed storage of key records and files inelectronic form increases the potential for unauthori0ed on-line access fromremote locations.

5oss of !ata1 The centrali0ed storage of data in electronic form increases the riskof data loss in the event the data file is altered or destroyed.

Re!uce! sereation of !uties1 The installation of T-#ased accounting systemscentrali0es many of the traditionally segregated manual tasks into one Tfunction.

5ack of tra!itional authori%ation1 T-#ased systems can #e programmed to initiatecertain types of transactions automatically ithout o#taining traditional manualapprovals.

+ee! for I# e$"erience1 As companies rely to a greater extent on T-#asedsystems, the need for personnel trained in T systems increases in order toinstall, maintain, and use systems.

+3



12-3 The audit trail represents the accumulation of source documents and records maintained#y the client to serve as support for the transactions occurring during the accounting period. Theintegration of T can change the audit trail #y converting many of the traditionally paper-#asedsource documents and records into electronic files that cannot #e visually o#served. ecausemany of the transactions are entered directly into the computer as they occur, some of thedocuments and records are even eliminated.

12-4 &andom error represents errors that occur in an inconsistent pattern. anual accountingsystems are especially prone to random errors that result from honest mistakes that occur asemployees perform day-to-day tasks. >hen those mistakes do not consistently occur hileperforming a particular task, errors are distri#uted randomly into the accounting records. Anexample of a random error is hen an employee accidentally pulls the rong unit price off theapproved price list hen preparing a sales invoice for a particular customer.

5ystematic error represents errors that occur consistently across all similar transactions.ecause T-#ased systems perform tasks uniformly for all transactions su#mitted, any mistakein softare programming results in the occurrence of the same error for every transactionprocessed #y the system. An example of a systematic error occurs hen a program that issupposed to post sales amounts to the accounts receiva#le su#sidiary records actually posts

the sales amount tice to customers$ accounts.

12-+ n most traditional accounting systems, the duties related to authori0ation oftransactions, recordkeeping of transactions, and custody of assets are segregated across threeor more individuals. As accounting systems make greater use of T, many of the traditionalmanually performed tasks are no performed #y the computer. As a result, some of thetraditionally segregated duties, particularly authori0ation and recordkeeping, fall under theresponsi#ility of T personnel. To compensate for the collapsing of duties under the T function,key T tasks related to programming, operation of hardare and softare, and data control aresegregated. 5eparation of those T functions restricts an T employee$s a#ility to inappropriatelyaccess softare and data files in order to misappropriate assets.

12-, (eneral controls relate to all aspects of the T function. They have a glo#al impact on allsoftare applications. 7xamples of general controls include controls related to theadministration of the T function< softare acquisition and maintenance< physical and on-linesecurity over access to hardare, softare, and related #ackup< #ack-up planning in the eventof unexpected emergencies< and hardare controls. A""lication controls apply to the processingof individual transactions. An example of an application control is a programmed control thatverifies that all time cards su#mitted are for valid employee id num#ers included in theemployee master file.

12- The typical duties often segregated ithin an T function include systems development,computer operations, and data control. 5ystems development involves the acquisition orprogramming of application softare. 5ystems development personnel ork ith test copies of

programs and data files to develop ne or improved application softare programs. !omputeroperations personnel are responsi#le for executing live production 9o#s in accordance ith a 9o#schedule and for monitoring consoles for messages a#out computer efficiency andmalfunctions. *ata control personnel are responsi#le for data input and output control. Theyoften independently verify the quality of input and the reasona#leness of output. y separatingthese functions, no one T employee can make changes to application softare or underlyingmaster files and then operate computer equipment to use those changed programs or data filesto process transactions.

+4



12-. f general controls are ineffective, there is a potential for material misstatement in eachcomputer-#ased accounting application, regardless of the quality of application controls. f, forexample, the systems development process is not properly controlled, there is a greater risk thatunauthori0ed and untested modifications to accounting applications softare have occurred. fgeneral controls are strong, there is a greater likelihood of placing greater reliance onapplication controls. 5tronger general controls should lead to greater likelihood that underlying

applications operate effectively and data files contain accurate, authori0ed, and completeinformation.

12-/ Application controls apply to the processing of specific individual transactions ithin atransaction cycle, such as a computer performed credit approval process for sales on account.*ue to the nature of these types of controls, application controls generally link directly to one ormore specific transaction o#9ectives. For example, the credit approval application control directlylinks to the existence o#9ective for sales. Auditors typically identify #oth manual and computer-performed application controls for each transaction-related o#9ective using a control risk matrixsimilar to the one discussed in !hapter 1B.

12-10 GAuditing around the computerH represents an audit approach here#y the auditor does

not use computer controls to reduce control risk. nstead, the auditor uses non-T controls tosupport a reduced control risk assessment. n these situations, the use of T does notsignificantly impact the audit trail. Typically, the auditor o#tains an understanding of internalcontrol and performs tests of controls, su#stantive tests of transactions, and account#alance verification

procedures in the same manner as if the accounting system as entirely manual. The auditor isstill responsi#le for gaining an understanding of general and application computer controls#ecause such knoledge is useful in identifying risks that may affect the financial statements.

12-11 The test data approach involves processing the auditor$s test data using the client$scomputer system and the client$s application softare program to determine hether the

computer-performed controls correctly process the test data. ecause the auditor designs thetest data, the auditor is a#le to identify hich test items should #e accepted or re9ected #y thecomputer. >hen using this approach the auditor should assess the folloing%

6o effectively does the test data represent all relevant conditions that theauditor ants to testP

6o certain is the auditor that the application programs #eing tested #y theauditor$s test data are the same programs as those used #y the client throughoutthe year to process actual transactionsP

6o certain is the auditor that test data is effectively eliminated from the client$srecords once testing is completedP

"arallel simulation ith audit softare involves the auditor$s use of an auditor-controlledsoftare program to perform parallel operations to the client$s softare #y using the same datafiles. ecause the auditor$s softare is designed to parallel an operation performed #y theclient$s softare, this strategy is referred to as parallel simulation testing. "arallel simulationcould #e used in the audit of payroll #y riting a program that calculates the accrued vacationpay lia#ility for each employee using information contained in the employee master file. Thetotal lia#ility calculated #y the auditor$s softare program ould then #e compared to the client$scalculation to determine if the lia#ility for accrued vacation pay is fairly stated at year-end.

++



12-12 'ften companies that purchase and install vendor developed softare applications oncomputer hard drives rely on T consultants to assist in the installation and maintenance of thatsoftare #ecause those companies do not have dedicated T personnel. Also, assignment ofresponsi#ility may reside ith user departments. !ompanies can reduce these risks related tonot having T personnel #y performing sufficient reference and #ackground checks a#outsoftare vendor and T consultant reputations. n addition, companies can load softare

programs onto hard drives in a format that does not permit changes #y client personnel,particularly non-T user department personnel ho may have primary responsi#ility for thesystem. !ompanies should also consider segregating key duties related to access to masterfiles and responsi#ilities for processing transactions.

12-13 ecause many companies that operate in a netork environment decentrali0e theirnetork servers across the organi0ation, there is an increased risk for a lack of security and lackof overall management of the netork operations. The decentrali0ation may lead to a lack ofstandardi0ed equipment and procedures. n many instances responsi#ility for purchasingequipment and softare, maintenance, administration, and physical security, often resides ithkey user groups rather than ith a centrali0ed T function. Also, netork-related softare oftenlacks the security features, including segregation of duties, typically availa#le in traditionally

centrali0ed environments #ecause of the ready access to softare and data #y multiple users.

12-14 n data#ase management systems, many applications share the same data files. Thisincreases risks in some cases given that multiple users, including individuals outsideaccounting, access and update data files. >ithout proper data#ase administration and accesscontrols, risks of unauthori0ed, inaccurate, and incomplete data files increase. Thecentrali0ation of data also increases the need to properly #ack-up data information on a regular#asis.

12-1+ An online sales ordering system poses many potential risks for an audit client. &isks thatmay exist include%

1 !ustomer data is suscepti#le to interception #y unauthori0ed third parties. 91 The client company$s data, programs, and hardare are suscepti#le to potential

interception or sa#otage #y external parties./1 An unauthori0ed third party may attempt to transact #usiness ith the client

company.

These risks can #e addressed #y the use of firealls, encryption techniques, and digitalsignatures. A fire'all is a system of hardare and softare that monitors and controls the floof e-commerce communications #y channeling all netork connections through a controlgateay. A fireall protects data, programs, and other T resources from external usersaccessing the system through netorks, such as the nternet. Encr)"tion techni,ues are #asedon computer programs that transform a standard message into a coded (encrypted) form. 'ne

key (the pu#lic key) is used for encoding the message and the other key (the private key) isused to decode the message. 7ncryption techniques protect the security of electroniccommunication during the transmission process. Finally, the use of !iital sinatures canenhance internal controls over the online sales order system #y authenticating the validity ofcustomers and other trading partners ho conduct #usiness ith the client company.

+,



12-1, t is unaccepta#le for an auditor to assume an independent computer service center isproviding relia#le accounting information to an audit client #ecause the auditor has no firsthandknoledge as to the adequacy of the service center$s controls. f the client$s service centerapplication is involved in processing significant financial data, the auditor must consider theneed to o#tain an understanding of internal control and test the service center$s controls.

The auditor can test the service center$s system #y use of the test data and other testsof controls. 'r, he or she may request that the service center auditor o#tain an understandingand test controls of the service center, hich are summari0ed in a special report issued #y theservice center auditor for use #y the customer$s auditor.

Chapter 13 - Overa Audit *an and Audit *ro5ram

13-1 The five types of tests auditors use to determine hether financial statements are fairlystated include the folloing%

"rocedures to gain an understanding of internal control Tests of controls 5u#stantive tests of transactions Analytical procedures Tests of details of #alances

>hile procedures to gain an understanding of internal control help the financialstatement auditor o#tain information to make an initial assessment of control risk, tests ofcontrols must #e performed as support of an assessment of control risk that is #elo maximum.The purpose of tests of controls is to o#tain evidence regarding the effectiveness of controls,hich may allo the auditor to assess control risk #elo maximum. f controls are found to #eeffective and functioning, the su#stantive evidence may #e reduced. 5u#stantive evidence iso#tained to reduce detection risk. 5u#stantive evidence includes evidence from su#stantivetests of transactions, analytical procedures, and tests of details of #alances.

For audits of internal control over financial reporting, the auditor only performs the firstto types of audit tests% procedures to o#tain an understanding of internal control and tests ofcontrols. ecause a pu#lic company auditor must issue a report on internal control over financialreporting, the extent of the auditor$s tests of controls must #e sufficient to issue an opinion a#outthe operating effectiveness of those controls. That generally requires a significant amount oftesting of controls over financial reporting.

13-2 Tests of controls are audit procedures to test the operating effectiveness of controlpolicies and procedures in support of a reduced assessed control risk. Tests of controls providethe primary #asis for a pu#lic company auditor$s report on internal controls over financialreporting. 5pecific accounts affected #y performing tests of controls for the acquisition andpayment cycle include the folloing% cash, accounts paya#le, purchases, purchase returns and

alloances, purchase discounts, manufacturing expenses, selling expenses, prepaid insurance,leasehold improvements, and various administrative expenses.

+



13-3 Tests of controls are audit procedures to test the operating effectiveness of controlpolicies and procedures in support of a reduced assessed control risk. 7xamples include%

1. The examination of vendor invoices for indication that they have #een clericallytested, compared to a receiving report and purchase order, and approved for payment.

+. 7xamination of employee time cards for approval of overtime hours orked.

3. 7xamination of 9ournal entries for proper approval.2. 7xamination of approvals for the rite-off of #ad de#ts.

5u#stantive tests of transactions are audit procedures testing for monetarymisstatements to determine hether the six transaction-related audit o#9ectives have #eensatisfied for each class of transactions. 7xamples are%

1. &ecalculation of amounts (quantity times unit selling price) on selectedsales invoices and tracing of amounts to the sales 9ournal.+. 7xamination of vendor invoices in support of amounts recorded in theacquisitions 9ournal for purchases of inventories.3. &ecalculation of gross pay for selected entries in the payroll 9ournal.

2. Tracing of selected customer cash receipts to the accounts receiva#lemaster file, agreeing customer names and amounts.

13-4 A test of control audit procedure to test that approved age rates are used to calculateemployees earnings ould #e to examine rate authori0ation forms to determine the existence of authori0ed signatures.

A su#stantive test of transactions audit procedure ould #e to compare a sample ofrates actually paid, as indicated in the earnings record, to authori0ed pay rates on rateauthori0ation forms.

13-+ The auditor resolves the pro#lem #y making assumptions a#out the results of the tests of controls and performing #oth the tests of controls and su#stantive tests of transactions on the

#asis of these assumptions. 'rdinarily the auditor assumes an effective system of internalcontrol ith fe or no exceptions planned. f the results of the tests of controls are as good as or #etter than the assumptions that ere originally made, the auditor can #e satisfied ith thesu#stantive tests of transactions, unless the su#stantive tests of transactions themselvesindicate the existence of misstatements. f the tests of controls results ere not as good as theauditor assumed in designing the original tests, expanded su#stantive tests must #e performed.

13-, The primary purpose of testing sales and cash receipts transactions is to evaluate theinternal controls so that the scope of the su#stantive tests of the account #alances may #e set.f the auditor performs the tests of details of #alances prior to testing internal controls, no #enefitill #e derived from the tests of controls. The auditor should attempt to understand the clients#usiness and internal controls as early as practical through the analysis of the accounting

system, tests of controls, and su#stantive tests of transactions.

+.



13- >hen the results of analytical procedures are different from the auditors expectationsand there#y indicate that there may #e a misstatement in the #alance in accounts receiva#le orsales, the auditor should extend the tests to determine hy the ratios are different fromexpectations. !onfirmation of accounts receiva#le and cutoff tests for sales are to proceduresthat can #e used to do this. 'n the other hand, if the ratios are approximately hat the auditorexpects, the other tests can #e reduced. This means that the auditor can satisfy the evidence

requirements in different ays and that analytical procedures and confirmation arecomplementary hen the results of the tests are #oth good.

13-. 5u#stantive tests of transactions are performed to verify the accuracy of a clientsaccounting system. This is accomplished #y determining hether individual transactions arecorrectly recorded and summari0ed in the 9ournals, master files, and general ledger. 5u#stantivetests of transactions are also concerned ith classes of transactions, such as payroll,acquisitions, or cash receipts. Tracing amounts from a file of vouchers to the acquisitions 9ournalis an example of a su#stantive test of transactions for the acquisition and payment cycle. Testsof details of #alances verify the ending #alance in an in!ivi!ual account (such as inventory,accounts receiva#le, or depreciation expense) on the financial statements. An example of a testof details of #alances for the acquisition and payment cycle is to physically examine a sample of

the clients fixed assets.

13-/ 1. &ontrol -- &om"uter verification of the customer3s cre!it limit . The presence of strong general controls over softare programs and master file changes can significantlyreduce the auditor$s testing of automated controls such as control Q1. 'nce it isdetermined that control Q1 is functioning properly, the auditor can focus su#sequent testson assessing hether any changes have occurred that ould limit the effectiveness ofthe control. 5uch tests might include determining hether any changes have occurred tothe program and hether these changes ere properly authori0ed and tested prior toimplementation. These are all tests of general controls over softare programs andmaster file changes.

+. &ontrol 9 I #he accounts receivable clerk matches bills of la!in4 salesinvoices4 an! customer or!ers before recor!in in the sales ;ournal1 This control is notan automated control, #ut is rather a manual control performed #y an employee. :eneralcontrols over softare programs and master file changes ould have little effect on theauditor$s testing of control Q+. f the auditor identifies control Q+ as a key control in thesales and collection cycle, he or she ould most likely examine a sample of theunderlying documents for the accounts receiva#le clerk$s initials and reperform thecomparisons.

+/



13-10 The audit of fixed asset additions normally involves the examination of invoices insupport of the additions and possi#ly the physical examination of the additions. Theseprocedures are normally performed on a test #asis ith a concentration on the more significantadditions. f the individual responsi#le for recording ne acquisitions is knon to haveinadequate training and limited experience in accounting, the sample si0e for the auditprocedures should #e expanded to include a larger sample of the additions for the year. n

addition, inquiry as to hat additions ere made during the year may #e made #y the auditor ofplant managers, the controller, or other operating personnel. The auditor should then search thefinancial records to determine that these additions ere recorded as fixed assets.

!are should also #e taken hen the repairs and maintenance expense account isanaly0ed since lack of training may cause some deprecia#le assets to #e expensed at the timeof acquisition.

13-11 The folloing shos hich types of evidence are applica#le for the five types of tests.

T* O$ V!DNC T*S O$ TSTS

"hysical examination

!onfirmation

*ocumentation

'#servation

nquiries of the client

&eperformance

Analytical procedures

Tests of details of #alances

Tests of details of #alances

All except analytical procedures

"rocedures to o#tain an understanding ofinternal control and tests of controls

All five types

Tests of controls, su#stantive tests oftransactions, and tests of details of #alances

Analytical procedures

13-12 :oing from most to least costly, the types of tests are%

Tests of details of #alances 5u#stantive tests of transactions Tests of controls "rocedures to o#tain an understanding of internal controls Analytical procedures

,0



13-13 ! represents the auditors assessment of the effectiveness of internal control. !3 represents the idea that the auditor chooses not to perform any tests of controls. 5ince no testsof controls are performed, no assurance can #e o#tained from controls and all assurance mustcome from su#stantive testing. This ould not represent the audit of a pu#lic company$sfinancial statements.

Tests of controls at the !1 level ould provide minimum control risk. This ould require

more testing of the controls than ould #e required at either !+ or !3. Testing controls at the !1 level allos the auditor to o#tain assurance from the controls, there#y alloing for a reduction inthe amount of su#stantive testing hich must #e performed to meet the level of accepta#le auditassurance. !1 reflects the level of testing of controls necessary for the audit of internal controlsover financial reporting required #y "!A' 5tandard +.

t ould #e a good decision to o#tain assurance from tests of controls at point !1 if thecost of su#stantive testing is considera#ly greater than tests of controls. 6oever, if the cost oftesting controls is high, it may #e a good decision to o#tain assurance at point !3.

At point !+, the auditor performs some tests of controls and is a#le to reduce control risk#elo maximum. "oint !+ ould #e appropriate if it is cost #eneficial for the auditor to o#tainassurance at a level #eteen the to extremes mentioned a#ove (!1 and !3).

13-14 efore reduced su#stantive testing is permitted, internal controls must #e effective and

the auditor must have found the results of the tests of controls satisfactory. !ost effectiveness of reduced assessed control risk should #e considered in making the decisions as to hether totest controls in the audit of a nonpu#lic company. The cost effectiveness of reduced control riskis an audit efficienc) issue. t is important to note, hoever, that tests of controls are alaysrequired in the integrated audit of a pu#lic company$s financial statements and internal controlover financial reporting. 13-1+ y identifying the #est mix of tests the auditor can accumulate sufficient competentevidence at minimum cost. The auditor can there#y meet the standards of the profession andstill #e cost effective and competitive.

13-1, The four-step approach to designing tests of controls and su#stantive tests oftransactions is as follos%

1. Apply the transaction-related audit o#9ectives to the class of transactions#eing tested.+. dentify specific control policies and procedures that should reducecontrol risk for each transaction-related audit o#9ective.3. *evelop appropriate tests of controls for each key control.2. *esign appropriate su#stantive tests of transactions consideringdeficiencies in internal control and expected results from 3 a#ove.

13-1 The approach to designing tests of controls and su#stantive tests of transactions (Figure13-2) emphasi0es satisfying the transaction-related audit o#9ectives developed in !hapters and 1B. &ecall that these o#9ectives focus on the proper functioning of the accounting system.

The methodology of designing tests of details of #alances (Figure 13-) emphasi0essatisfying the #alance-related audit o#9ectives developed in !hapter . The primary focus ofthese o#9ectives is on the fair presentation of account #alances in the financial statements.

,1



13-1. t is desira#le to design tests of details of #alances #efore performing tests of controlsand su#stantive tests of transactions to ena#le the auditor to determine if the overall plannedevidence is the most efficient and effective in the circumstances. n order to do this, the auditormust make assumptions a#out the results of the tests of controls and su#stantive tests oftransactions. 'rdinarily the auditor ill assume no significant misstatements or control pro#lemsin tests of controls and su#stantive tests of transactions unless there is reason to #elieve

otherise. f the auditor determines that the tests of controls and su#stantive tests oftransactions results are different from those expected, the amount of testing of details of#alances must #e altered.

13-1/ f tolera#le misstatement is lo, and inherent risk and control risk are high, planned testsof details of #alances hich the auditor must perform ill #e high. An increase in tolera#lemisstatement or a reduction of either inherent risk or control risk ill lead to a reduction in theplanned tests of details of #alances.

13-20 The nine #alance-related audit o#9ectives and related procedures are as follos%

GN#A)9A)ANC-#)ATD A"D!T O9:CT!V S*C!$!C O9:CT!V A"D!T *#OCD"#

*etail tie-in nventory on the inventorysummary agrees ith thephysical count, the extensionsare correct, and the total iscorrectly added and agrees iththe general ledger.

!heck extensions of price times quantityon a sample #asis, foot the detailedinventory summary, and trace the #alanceto the general ledger and financialstatements.

7xistence nventory as stated in financial

statements actually exists.

Trace inventory from final inventory

summary to actual inventory andphysically count selected items.

!ompleteness 7xisting inventory items have#een counted and included inthe financial statements.

5elect items from the physical inventoryand trace to the clients final summary tomake sure that all items are included.

Accuracy nventory items included in thefinancial statements are statedat the correct amounts.

"erform price tests of inventory #yexamining supporting vendors invoicesfor selected inventory items and reverifyprice times quantity.

!lassification nventory as included in thefinancial statements is properly

classified.

!ompare the classification of inventoryinto ra materials, ork in process, and

finished goods #y comparing thedescription on physical inventory counttags ith the clients final inventory listing.

,2



!utoff nventory cutoff is properlyrecorded at the #alance sheetdate.

Trace selected receiving reports severaldays #efore and after the #alance sheetdate to determine hether inventorypurchases are recorded in the properperiod and related physical inventory

counts are included or excluded frominventory.

&eali0a#le value nventory on the financialstatements excludes unusa#leitems.

nquire of factory employees andmanagement regarding o#solescence ofinventory, and examine storeroom forevidence of damaged or o#soleteinventory.

&ights ando#ligations

nventory items in the financialstatements are oned #y theclient.

&evie contracts ith suppliers andcustomers for the possi#ility of theinclusion of consigned or other non-oned inventory.

"resentation anddisclosure

nventory and related accountsin the inventory andarehousing cycle are properlypresented and disclosed.

7xamine financial statements for properpresentation and disclosure includingproper description of pledged inventoryand inclusion of significant sales andpurchase commitments.

13-21 Auditors frequently consider it desira#le to perform audit tests throughout the year ratherthan aiting until year-end #ecause of the !"A firms difficulty of scheduling personnel. *ue tothe uneven distri#ution of the year-end dates of their clients, there is a shortage of personnel

during certain periods of the year and excess availa#le time at other periods. The proceduresthat are performed at a date prior to year-end are often dependent upon adequate internalcontrols and hen the client ill have the information availa#le. Additionally, pu#lic companyauditors must #egin their testing of controls earlier in the year to ensure they are a#le to test asufficient sample of controls for operating effectiveness. 5ome controls may only #e performedmonthly or quarterly. Thus, the pu#lic company auditor must #egin testing early in the year sothat there is a sufficient num#er of months or quarters to test.

"rocedures that may #e performed prior to the end of the year are%

1. 4pdate fixed asset schedules.+. 7xamine ne loan agreements and other legal records.3. /ouch certain transactions.

2. Analy0e changes in the clients accounting systems.=. &evie minutes of #oard of directors meetings.. f the client has strong internal control, the folloing procedures may #e

performed ith minor revie and updating at year-end%(a) '#servation of physical inventories<(#) !onfirmation of accounts receiva#le #alances<(c) !onfirmation and reconciliation of accounts paya#le #alances.

,3



Chapter 14 - Audit of the Saes and Coection C7ce@ Tests ofContros and Su6stantive Tests of Transactions

14-1 a. The bill of la!in is a document prepared at the time of shipment of goods to acustomer indicating the description of the merchandise, the quantity shipped, and

other relevant data. Formally, it is a ritten contract of the shipment and receiptof goods #eteen the seller and carrier. t is also used as a signal to #ill theclient. The original is sent to the customer and one or more copies are retained.

#. A sales invoice is a document indicating the description and quantity of goodssold, the price including freight, insurance, terms, and other relevant data. t isthe method of indicating to the customer the amount oed for the sale and thedue date of the payments. The original is sent to the customer and one or morecopies are retained. The sales invoice is the document for recording sales in theaccounting records.

c. The cre!it memo is a document indicating a reduction in the amount due from acustomer #ecause of returned goods or an alloance granted. t often takes thesame general form as a sales invoice, #ut it reduces the customers accounts

receiva#le #alance rather than increasing it.d. The remittance advice is a document that accompanies the sales invoice mailed

to the customer and can #e returned to the seller ith the cash payment. t isused to indicate the customer name, sales invoice num#er, and the amount ofthe invoice hen the payment is received. A remittance advice is used to permitthe immediate deposit of cash as a means of improving control over the custodyof assets.

e. The monthl) statement to customers is the document prepared monthly and sentto each customer indicating the #eginning #alance of that customers accountsreceiva#le, the amount and date of each sale, cash payment received, creditmemos issued, and the ending #alance due. t is, in essence, a copy of thecustomers portion of the accounts receiva#le master file.

14-2 "roper credit approval for sales helps minimi0e the amount of #ad de#ts and thecollection effort for accounts receiva#le #y requiring that each sale #e evaluated for collectionpotential.

Adequate controls in the credit function ena#le the auditor to place more reliance on theclients estimate of uncollecti#le accounts. >ithout these controls, the auditor ould have tomake his or her on credit checks on the customers in order to #e convinced that the alloancefor uncollecti#le accounts is reasona#le.

14-3 The charge-off of uncollecti#le accounts receiva#le is a process here#y the companyrites off receiva#les already in existence that it decides ill not #e collected. This usuallyoccurs after a customer files for #ankruptcy or hen the account is turned over to a collection

agency. The #ad de#t expense is a provision for sales that the company ill #e una#le to collectin the future. t is an estimate used #ecause of the matching concept in accounting. ad de#texpense is audited #y examining past trends in uncollecti#ility, as it is a pro9ection of futureuncollecti#les.

,4



14-3, continued

The uncollecti#le accounts rite-off must #e carefully audited to assure that accountsthat have #een paid are not ritten off to cover up a defalcation. This is done #y examining theauthori0ation for the rite-off and the correspondence in the files concerning that account, andpossi#ly #y confirming accounts receiva#le.

14-4 est5ellers.com could integrate its online ordering system ith its inventory system sothat a #ook shipment is made only after the customer$s credit card company approves thecustomer$s purchase. ecause credit card issuers often transfer funds electronically almostimmediately after a sale, est5ellers.com could also set up their system to ship #ooks only after payment has #een received #y the credit card issuer. Finally, est5ellers.com could arrangeith an online credit service #ureau to run credit checks on customers purchasing over a presetminimum amount.

Although est5ellers.com sells its goods through the nternet, the company should still recordsales revenue hen the #ooks are shipped to customers.

14-+

T#ANSACT!ON-#)ATDA"D!T O9:CT!V ' !NT#NA) CONT#O)S

1. &ecorded sales are for shipmentsactually made to existing customers(existence).

&ecording of sales is supported #y authori0edshipping documents and approved customerorders.

!redit is authori0ed #efore shipment takesplace.

5ales invoices are prenum#ered and properlyaccounted for.

'nly customer num#ers existing in the

computer data files are accepted hen they areentered.

onthly statements are sent to customers<complaints receive independent follo-up.

+. 7xisting sales transactions arerecorded (completeness).

5hipping documents are prenum#ered andaccounted for.

5ales invoices are prenum#ered and accountedfor.

,+



14-+ <continued=


3. &ecorded sales are for the amount of

goods shipped and are correctly #illedand recorded (accuracy).

*etermination of prices, terms, freight, and

discounts is properly authori0ed. nternal verification of invoice preparation. Approved unit selling prices are entered into the

computer and used for sales. atch totals are compared ith computer

summary reports.

2. 5ales transactions are properlyclassified (classification).

4se of adequate chart of accounts. nternal revie and verification.

=. 5ales are recorded on the correctdates (timing).

"rocedures requiring #illing and recording ofsales on a daily #asis as close to the time ofoccurrence as possi#le.

nternal verification.

. 5ales transactions are properlyincluded in the accounts receiva#lemaster file and are correctlysummari0ed (posting andsummari0ation).

&egular monthly statements to customers. nternal verification of accounts receiva#le

master file contents. !omparison of accounts receiva#le master file

or trial #alance ith general ledger #alance.

14-,

#ests of controls:

1. 'n a sample of sales invoices, examine proper authori0ation and indication ofinternal verification of sales amounts.

+. 7xamine approved computer printout of unit selling prices.3. 7xamine file of #atch totals for initials of data control clerk< compare totals to

summary reports.

*ubstantive tests of transactions:

1. &ecompute information on sales invoices.

+. Trace entries in sales 9ournal to related sales invoices.3. Trace detail on sales invoices to shipping documents, approved price lists, and

customers orders.

,,



14- The most important duties that should #e segregated in the sales and collection cycleare%

1. &eceiving orders for sales+. 5hipping goods3. illing customers and recording sales

2. aintaining inventory records=. aintaining general accounting records. aintaining detailed accounts receiva#le recordsD. "rocessing cash receipts@. :ranting credit and pursuing unpaid accounts

5egregation of duties should #e used extensively in the sales and collection cycle for toreasons. First, cash receipts are su#9ect to easy manipulation. 5econd, the large num#er and nature of transactions ithin the cycle make the procedure of cross-checking, hereone employees duties automatically serve to verify the accuracy of anothers, highlydesira#le.

f the asset-handling activities (shipping goods and processing cash receipts) arecom#ined ith their respective accounta#ility activities (maintaining inventory, accountsreceiva#le, and general accounting records), a serious deficiency ith respect to safeguardingthose assets exists. t ould #e easy for an employee, #y either omitting or adding an entry, touse the companys assets for his or her on purpose. f the credit granting function is com#inedith the sales function, there may #e a tendency of sales staff to optimi0e volume even at theexpense of high #ad de#t rite-offs.

14-. The use of prenum#ered documents is meant to prevent the failure to #ill or record salesas ell as to prevent duplicate #illings and recordings. An example of a useful control to providereasona#le assurance that all shipments are #illed, is for the #illing clerk to file a copy of allshipping documents in sequential order after a shipment has #een #illed. "eriodically, someonecan account for all num#ers in the sequence and investigate the reason for missing documents.The same type of a useful test in this area is to account for the sequence of duplicate salesinvoices in the sales 9ournal, atching for omitted num#ers, duplicate num#ers, or invoicesoutside the normal sequence. This test simultaneously provides evidence of #oth theEexistenceE and EcompletenessE o#9ectives.

14-/ 1. !redit is authori0ed #efore a sale takes place.

#est % Analy0e the alloance for uncollecti#le accounts and rite-offs ofaccounts receiva#le during the period to determine the effectiveness ofthe credit approval system.

+. :oods are shipped only after proper authori0ation.

#est % &evie physical inventory shortages to determine the effectiveness ofinventory control.

3. "rices, including payment terms, freight, and discounts, are properly authori0ed.

#est % !ompare actual price charged for different products, including freight andterms, to the price list authori0ed #y management.

,



14-10 The purpose of footing and crossfooting the sales 9ournal and tracing the totals to thegeneral ledger is to determine that sales transactions are properly included in the accountsreceiva#le master file and are correctly summari0ed. The auditor ill make a sample selectionfrom the sales 9ournal to perform tests of controls and su#stantive tests of transactions, so he or she must determine that the general ledger agrees ith the sales 9ournal.

14-11 The verification of sales returns and alloances is quite different from the verification ofsales for three primary reasons%

1. 5ales returns and alloances are normally an insignificant portion of operationsand therefore receive little attention from the auditor.

+. The primary emphasis the auditor places on sales returns and alloances is todetermine that returns and alloances are properly authori0ed and that sales arenot overstated at year-end and su#sequently reversed #y the issuance of returns.

3. The completeness o#9ective cannot #e ignored #ecause unrecorded salesreturns and alloances can materially overstate net income.

14-12 !ash is the most liquid asset that a company ons and thus it is the most likely target ofmisappropriation. The emphasis the auditor places on the possi#ility of misappropriation of cashis not inconsistent ith his or her responsi#ility, hich is to determine the fairness of thepresentation of the financial statements. f material fraud has occurred, and it is not fullydisclosed in the financial statements, those statements are not fairly presented.

,.



14-13


1. &ecorded cash receipts are forfunds actually received #y thecompany (existence).

5eparation of duties #eteen handling cash andrecord keeping.

ndependent reconciliation of #ank accounts.

+. !ash received is recorded in thecash receipts 9ournal(completeness).

5eparation of duties #eteen handling cash andrecord keeping.

4se of remittance advices or a prelisting of cash. mmediate endorsement of incoming checks. nternal verification of the recording of cash

receipts. &egular monthly statements to customers.

3. !ash receipts are deposited and

recorded at the amounts received(accuracy).

5ame as + a#ove. Approval of cash discounts. &egular reconciliation of #ank accounts. atch totals are compared ith computer

summary reports.

2. !ash receipts transactions areproperly classified (classification).

4se of adequate chart of accounts. nternal revie and verification.

=. !ash receipts are recorded on thecorrect dates (timing).

"rocedure requiring recording of cash receipts ona daily #asis.

nternal verification.

. !ash receipts are properly

included in the accounts receiva#lemaster file and are correctlysummari0ed (posting andsummari0ation).

&egular monthly statements to customers. nternal verification of accounts receiva#le master

file contents. !omparison of accounts receiva#le master file or

trial #alance totals ith general ledger #alance.

14-14 Audit procedures that the auditor can use to determine hether all cash receipts ererecorded are%

*iscussion ith personnel and o#servation of the separation of duties #eteenhandling cash and record keeping.

Account for numerical sequence of remittance advices or examine prelisting ofcash receipts.

'#serve immediate endorsement of incoming checks. 7xamine indication of internal verification of the recording of cash receipts. '#serve hether monthly statements are #eing sent to customers. Trace from remittance advices or prelisting to cash receipts 9ournal.

,/



14-1+ "roof of cash receipts is a procedure to test hether all recorded cash receipts have#een deposited in the #ank account. n this test, the total cash receipts recorded in the cashreceipts 9ournal for a period of time, such as a month, are reconciled to the actual depositsmade to the #ank during the same time period. The procedure is not useful to discover cashreceipts that have not #een recorded in the 9ournals or time lags in making deposits, #ut it isuseful to discover recorded cash receipts that have not #een deposited, unrecorded deposits,

unrecorded loans, #ank loans deposited directly into the #ank account, and similarmisstatements.

14-1, apping is the postponement of entries for the collection of receiva#les to conceal anexisting cash shortage. The fraud is perpetrated #y someone ho records cash in the cashreceipts 9ournal and then enters them into the computer system. The person defers recordingthe cash receipts from one customer and covers the shortage ith receipts from anothercustomer. These in turn are covered #y the receipts from a third customer a fe days later. Theemployee must either continue to cover the shortage through lapping, replace the stolen money,or find another ay to conceal the shortage.

This fraud can #e detected #y comparing the name, amount and dates shon onremittance advices to cash receipts 9ournal entries and related duplicate deposit slips. 5ince the

procedure is relatively time-consuming, auditors ordinarily perform the procedure only herethere is a specific concern ith fraud #ecause of internal control deficiencies discovered.

14-1 The audit procedures most likely to #e used to verify accounts receiva#le charged off asuncollecti#le and the purpose of each procedure are as follos%

7xamine approvals #y the appropriate persons of individual accounts charged off.The purpose is to determine that charge-offs are approved.

7xamine correspondence in clients files that indicates the uncollecti#ility of theaccounts for a selected num#er of charge-offs. The purpose is to determine thatthe account appears to #e uncollecti#le.

7xamine *un and radstreet credit records as an indication of the uncollecti#ility

of an account. The purpose is the same as the previous procedure. !onsider the reason for the charge-off compared to the company policy for

riting off uncollecti#le accounts. The purpose is to determine hether or notcompany policy is #eing folloed.

14-1. The primary o#9ective of the tests of controls and su#stantive tests of transactions forsales and cash receipts is to determine hether or not the auditor may rely on internal controlsto produce accurate information. f it is determined through tests of controls and su#stantivetests of transactions that the system provides relia#le information as to accounts receiva#le#alances, the auditor may reduce the sample si0e for the confirmation of accounts receiva#leand ad9ust the type of confirmation and timing of the tests. f the system is not consideredeffective #ecause of deficiencies in internal control, the sample si0e must #e increased, positive

confirmations ill pro#a#ly #e necessary, and the confirmations ill most likely #e as of the#alance sheet date.

0



14-1/ t is often accepta#le to perform tests of controls and su#stantive tests of transactions atan interim date. The auditor may decide it is necessary to test the untested period at year-end. tis accepta#le to perform tests of controls and su#stantive tests of transactions for sales andcash receipts at an interim date and not perform additional tests of the system at year-endunder the folloing circumstances%

The auditor #elieves that internal controls are effective. The auditor does not anticipate significant changes in the internal controls during

the remaining period. The transactions normally occurring #eteen the completion of the tests of

controls and su#stantive tests of transactions and the end of the year are similarto the transactions prior to the test date.

The remaining period is not too long.

14-20 :enerally, successful tests of controls and su#stantive tests of transactions allo for areduction of tests of details of #alance at year-end. 6oever, *iane 5mith chose the month ofarch, hich only represents one-telfth of the year, as her test period. >ith such a short testperiod, *iane cannot conclude that she has selected a representative sample from the totalpopulation< therefore, ithout testing additional months (consensus of several !"A firmsrequires at least nine months coverage), *iane should not change the scope of her tests ofdetails of #alances at year-end.

Chapter 1, - Competin5 the Tests in the Saes and Coection C7ce@Accounts #eceiva6e

1,-1 Tests of details of #alances are designed to determine the reasona#leness of the#alances in sales, accounts receiva#le, and other account #alances that are affected #y the

sales and collection cycle. 5uch tests include confirmation of accounts receiva#le, andexamining documents supporting the #alance in these accounts.Tests of controls and su#stantive tests of transactions for the sales and collection cycle

are intended to determine the effectiveness of internal controls and to test the su#stance of thetransactions that are produced #y this cycle. 5uch tests consist of activities such as examiningsales invoices in support of entries in the sales 9ournal, reconciling cash receipts, or revieingthe approval of credit.

The results of the tests of controls and su#stantive tests of transactions affect theprocedures, sample si0e, timing and items selected for the tests of details of #alances (i.e.,effective internal controls ill result in reduced testing hen compared to the tests of detailsrequired in the case of inadequate internal controls). The results of tests of controls also affectthe pu#lic company auditor$s report on internal controls over financial reporting.

1



1,-2 5A5 D (A4 33B.+B) discusses the use of negative accounts receiva#le confirmations asfollos%

The negative form requests the recipient to respond only if he or she disagrees ith theinformation stated on the request. egative confirmation requests may #e used toreduce audit risk to an accepta#le level hen (a) the com#ined assessed level of

inherent and control risk is lo, (#) a large num#er of small #alances is involved, and (c)the auditor has no reason to #elieve that the recipients of the requests are unlikely togive them consideration. For example, in the examination of demand deposit accounts ina financial institution, it may #e appropriate for an auditor to include negativeconfirmation requests ith the customers$ regular statements hen the com#inedassessed level of inherent and control risk is lo and the auditor has no reason to#elieve that the recipients ill not consider the requests. The auditor should considerperforming other su#stantive procedures to supplement the use of negativeconfirmations.

The preceding requirement that negative confirmations are considered appropriatehere the internal controls of the sales and collection cycle are effective is violated #y !ynthia

&o#erts approach. ot only is her approach questiona#le from the standpoint thatnonresponses have not necessarily proved the existence of the receiva#le, #ut her confirmationat an interim date requires her to assume an assessed control risk less than maximum, #ut shehas not tested the related internal controls to 9ustify this assumption.

1,-3 The folloing are analytical procedures for the sales and collection cycle, and potentialmisstatements uncovered #y each test. 7ach ratio should #e compared to previous years.

ANA)T!CA) *#OCD"# *OTNT!A) %!SSTAT%NT

1. :ross margin #y product line ncluding in the physical inventory items for

hich the corresponding lia#ility had not yet#een recorded.

+. 5ales returns andalloances as a percentageof gross sales #y product lineor segment

All returns ere not recorded, or shipments tocustomers ere not in accordance ithspecifications and ere returned (this couldresult in significant operating pro#lems).

3. Trade discounts taken as apercentage of net sales

*iscounts that ere taken #y customers andalloed #y the company ere not recorded.

2. ad de#ts as a percentageof gross sales

isstatement in determining the alloance foruncollecti#le accounts.

=. *ays sales in receiva#lesoutstanding

A pro#lem ith collections, an understatement of #ad de#ts and alloance for uncollecti#leaccounts.

. Aging categories as apercentage of accountsreceiva#les

!ollection pro#lems and understatement ofalloance for uncollecti#le accounts.

2



D. Alloance for uncollecti#leaccounts as a percentage ofaccounts receiva#le

isstatement in determining the alloance foruncollecti#le accounts.

@. !omparison of the #alancesin individual customers

accounts over a statedamount ith their #alances inthe previous year

A pro#lem ith collections and therefore amisstatement of the alloance for uncollecti#le

accounts.

1,-4 The folloing are #alance-related audit o#9ectives and related audit procedures for theaudit of accounts receiva#le.

9A)ANC-#)ATD A"D!TO9:CT!V A"D!T *#OCD"#

Accounts receiva#le in the agedtrial #alance agree ith relatedmaster file amounts< the total iscorrectly added and agrees ith thegeneral ledger.

Trace tenty accounts from the trial#alance to the related accounts in themaster file.

Foot to pages of the trial #alance, total allpages, and trace totals to the generalledger.

The accounts receiva#le in theaged trial #alance exist.

!onfirm accounts receiva#le using positiveconfirmations. !onfirm all amounts overL1=,BBB and a nonstatistical sample of theremainder.

7xisting accounts receiva#le are

included in the aged trial #alance.

Trace ten accounts from the accounts

receiva#le master file to the aged trial #alance.

Accounts receiva#le in the trial#alance are accurately recorded.

!onfirm accounts receiva#le using positiveconfirmations. !onfirm all amounts overL1=,BBB and a nonstatistical sample of theremainder.

Accounts receiva#le in the agedtrial #alance are properly classified.

&evie the receiva#les listed on the aged trial#alance for notes and related party receiva#les.

Transactions in the sales andcollection cycle are recorded in theproper period.

5elect the last 1B sales transactions from thecurrent years sales 9ournal and the first 1Bfrom the su#sequent years and trace each one

to the related shipping documents, checking for the date of actual shipment and the correctrecording.

Accounts receiva#le in the trial#alance are oned.

&evie the minutes of the #oard of directors for any indication of pledged or factored accountsreceiva#le.

3



Accounts receiva#le in the trial#alance are stated at reali0a#levalue.

*iscuss ith the credit manager the likelihoodof collecting older accounts. 7xaminesu#sequent cash receipts and the credit file onolder accounts to evaluate hether receiva#lesare collecti#le.

Accounts in the sales and collectioncycle are properly presented anddisclosed.

&evie the minutes of the #oard of directorsmeetings for any indication of pledged orfactored accounts receiva#le.

1,-+ The most important o#9ectives satisfied #y confirmations are existence, rights, andaccuracy. n extreme cases, confirmations are also useful tests for cutoff. 5ometimesconfirmations may also help the auditor satisfy the completeness o#9ective.

1,-, A necessary audit procedure is to test the information on the clients trial #alance fordetail tie-in. The footing in the total column and the columns depicting the aging must #echecked and the total on the trial #alance reconciled to the general ledger to determine that allaccounts are included in the listing.

The master file records are the tie-in #eteen tests of controls, su#stantive tests oftransactions, and tests of details of #alances. The aged trial #alance is the listing of the masterfile. 5ince the auditor uses the aged trial #alance in tests of details, he or she must #e sure thatinformation is the same as that tested in tests of controls and su#stantive tests of transactions.n addition, a sample of individual #alances is traced to the master file to determine that the trial#alance has #een properly summari0ed from the master file. n most cases, it ill not #enecessary to trace each amount to the master file unless a significant num#er of misstatementsis noted and it is determined that reliance cannot #e place upon the trial #alance ith less than1BBN testing. ormally a sample of entries on the trial #alance could #e traced to the master fileand ould #e sufficient to dra a conclusion as to the overall accuracy of the trial #alance.

1,- The purpose of the accuracy tests of gross accounts receiva#le is to determine the

correctness of the total amounts receiva#le from customers. These tests normally consist ofconfirmation of accounts receiva#le or examination of shipping documents in support of theshipment of goods to customers.

The purpose of the test of the reali0a#le value of receiva#les is to estimate the amount of the accounts receiva#le #alance that ill not #e collected. To estimate this amount, the auditornormally revies the aging of the accounts receiva#le, analy0es su#sequent cash payments #ycustomers, discusses the collecti#ility of individual accounts ith client personnel, and examinescorrespondence and financial statements of significant customers.

1,-. n most audits it is more important to carefully test the cutoff for sales than for cashreceipts #ecause sales cutoff misstatements are more likely to affect net earnings than are cashreceipt cutoff misstatements. !ash receipt cutoff misstatements generally lead to a

misclassification of accounts receiva#le and cash and, therefore, do not affect income.To perform a cutoff test for sales, the auditor should o#tain the num#er of the last

shipping document issued #efore year-end and examine shipping documents representingshipments #efore and after year-end and the related sales invoices to determine that theshipments ere recorded as sales in the appropriate period.

The propriety of the cash receipts cutoff is determined through tests of the year-end#ank reconciliation. *eposits in transit at year-end should #e traced to the su#sequent #ankstatement. Any delays in crediting deposits #y the #ank should #e investigated to determinehether the cash receipts #ooks ere held open.

4



1,-10 There are to common types of confirmations used for confirming accounts receiva#le%EpositiveE confirmations and EnegativeE confirmations. A positive confirmation is a letter,addressed to the de#tor, requesting that the recipient indicate directly on the letter hether thestated account #alance is correct or incorrect and, if incorrect, #y hat amount. A negativeconfirmation is also a letter, addressed to the de#tor, #ut it requests a response only if therecipient disagrees ith the amount of the stated account #alance. A positive confirmation is

more relia#le evidence #ecause the auditor can perform follo-up procedures if a response isnot received from the de#tor. >ith a negative confirmation, failure to reply must #e regarded asa correct response, even though the de#tor may have ignored the confirmation request.

'ffsetting the relia#ility disadvantage, negative confirmations are less expensive to sendthan positive confirmations, and thus more of them can #e distri#uted for the same total cost.The determination of hich type of confirmation to #e sent is an auditors decision, and it should#e #ased on the facts in the audit. 5A5 D (A4 33B) states that it is accepta#le to use negativeconfirmations only hen all of the folloing circumstances are present%

Accounts receiva#le is made up of a large num#er of small accounts. !om#ined assessed control risk and inherent risk is lo. There is no reason to #elieve that the recipients of the confirmations are unlikely

to give them consideration.

Typically, hen negative confirmations are used, the auditor is using a reduced controlrisk assessment in the audit of accounts receiva#le. t is also common to use negativeconfirmations for audits of hospitals, retail stores, and other industries here the receiva#les aredue from the general pu#lic. n these cases, far more assurance is o#tained from tests ofcontrols and su#stantive tests of transactions than from confirmations.

t is also common to use a com#ination of negative and positive confirmations #ysending the positives to accounts ith large #alances and negatives to those ith small#alances. This allos the auditor to focus the confirmation testing on large account #alances,hile still testing a representative sample from the rest of the population at minimal cost.

1,-11 t is accepta#le to confirm accounts receiva#le prior to the #alance sheet date if theinternal controls are adequate and can provide reasona#le assurance that sales, cash receipts,and other credits are properly recorded #eteen the date of the confirmation and the end of theaccounting period. 'ther factors the auditor is likely to consider in making the decision are themateriality of accounts receiva#le and the auditors exposure to lasuits #ecause of thepossi#ility of client #ankruptcy and similar risks. f the decision is made to confirm accountsreceiva#le prior to year-end, it is necessary to test the transactions occurring #eteen theconfirmation date and the #alance sheet date #y examining internal documents and performinganalytical procedures at year-end.

1,-12 The most important factors affecting the sample si0e in confirmations of accountsreceiva#le are%

Tolera#le misstatement nherent risk (relative si0e of total accounts receiva#le, num#er of accounts, prior

year results, and expected misstatements) !ontrol risk Achieved detection risk from other su#stantive tests (extent and results of

su#stantive tests of transactions, analytical procedures, and other tests ofdetails)

Type of confirmation (negatives normally require a larger sample si0e)

,



1,-13 n most confirmations of accounts receiva#le, some type of stratification is desira#le. Atypical approach to stratification is to consider #oth the si0e of the outstanding #alance and thelength of time an account has #een outstanding as a #asis for selecting the #alances forconfirmation, since these are the accounts that are more likely to include a significantmisstatement. t is also important to sample some items from every material stratum of the

population. 4sing this approach, the auditor ill pay careful attention to the accounts in hichmisstatements are most likely to occur and ill follo the guidelines set forth in !hapter 1=regarding the need to o#tain a representative sample of the population.

1,-14 Alternative procedures are procedures performed on a positive confirmation not returned#y the de#tor using documentation evidence to determine hether the recorded receiva#leexists and is collecti#le. t is common to send second requests for confirmations and sometimeseven third requests. 7ven ith these efforts, some customers do not return the confirmations, soit is necessary to follo up ith alternative procedures. The o#9ective of the alternativeprocedures is to determine, #y a means other than confirmation, hether the unconfirmedaccount existed and as properly stated at the confirmation date. For any confirmation notreturned, the folloing documentation can #e examined to verify the existence and accuracy of

individual sales transactions making up the ending #alance in accounts receiva#le%

1. *ubse,uent cash recei"ts 7vidence of the receipt of cash su#sequent to theconfirmation date includes examining remittance advice, entries in the cashreceipts records, or perhaps even su#sequent credits in the accounts receiva#lemaster file. The examination of evidence of su#sequent cash receipts is usuallythe most useful alternative procedure #ecause it is reasona#le to assume that acustomer ould not make a payment unless it as a valid receiva#le. 'n theother hand, the fact of payment does not esta#lish hether there as ano#ligation on the date of the confirmation. n addition, care should #e used tomatch each unpaid sales transaction ith evidence of its payment as a test fordisputes or disagreements over individual outstanding invoices.

+. Du"licate sales invoices These are useful to verify the actual issuance of a salesinvoice and the actual date of the #illing.

3. *hi""in !ocuments These are important to esta#lish hether the shipment asactually made and as a test of cutoff.

2. &orres"on!ence 'ith the client 4sually it is unnecessary to reviecorrespondence as a part of alternative procedures, #ut it can #e used todisclose disputed and questiona#le receiva#les not uncovered #y other means.

The extent and nature of the alternative procedures depends primarily upon themateriality of the unconfirmed accounts, the nature and extent of the misstatements discoveredin the confirmed responses, the su#sequent cash receipts of the unconfirmed accounts, and theauditors evaluation of the effectiveness of internal controls. t is normally desira#le to account

for all unconfirmed #alances ith alternative procedures, even if the amounts are small, as ameans of properly generali0ing from the sample to the population.

Solutions to Review Questions ACCT 425

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