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ACCT 4240 Hand-Out Cases # 125 Dr.

Zabi Rezaee

Case 1 Characteristics of Auditing

The following three statements are representative of attitudes and opinions sometimes encountered by CPAs in their professional practices. 1. Todays audit consists of testing only selected transactions. This is dangerous because testing depends upon the auditors judgment, which may be defective. An audit can be relied upon only if every transaction is verified. 2. An audit by a CPA is essentially negative and contributes to neither the gross national product nor the general well-being of society. The auditor does not create but merely checks what someone else has done. 3. One should read the footnotes to financial statements, even though they are often presented in technical language and are incomprehensible. The auditor may reduce exposure to third-party liability by stating something in the footnotes that contradicts completely what has been presented in the balance sheet or income statement. REQUIRED: Evaluate each of the above statements and indicate: A. Areas of agreement with the statement, if any. B. Areas of misconception, incompleteness, or fallacious reasoning included in the statement, if any. Complete your discussion of each statement (both parts A and B) before going on to the next statement.

Case 2
Leigh Whitney finished high school at the top of her class and was a straight-A student at Central State College, where she was enrolled in the business department for nearly three years. While attending college, she worked in the general accounting office of Century Manufacturing Company. She advanced so rapidly that she dropped out of college and devoted her time to work and a home-study course in accounting. In addition to completing the home-study course, she had assisted the public accountants for three years in conducting the audit of Century Manufacturing Company. One of the managers of the auditing firm told Whitney, in confidence, that he would rather have her as an assistant than either of the two junior accountants assigned to the audit. Leigh has come to you to discuss establishing a firm to practice public accounting. What would you tell her, particularly concerning the first general standard of accounting?

Case 3 Comparative Financial Statements

J. Childs, CPA, has completed the examination of the financial statements of Straw Corporation as of and for the year ended December 31, 19x1. Childs also examined and reported on the Straw financial statements for the prior year. Childs drafted the following report for 19x1: March 15, 19x2 We have examined the balance sheet and statements of income and retained earnings of Straw Corporation as of December 31, 19x1. Our examination was made in accordance with generally accepted accounting standards and accordingly included such tests of the accounting records as we considered necessary in the circumstances. In our opinion, the above-mentioned financial statements are accurately prepared and fairly presented in accordance with generally accepted accounting principles in effect at December 31, 19x1. J. Childs, CPA Other information: 1. Straw is presenting comparative financial statements. 2. Straw does not wish to present a statement of changes in financial position for either year. 3. During 19x1, Straw changed its method of accounting for long-term construction contracts and properly reflected the effect of the change in the current year financial statements and restated the prior-year statements. Childs is satisfied with Straws justification for making the change. The change is discussed in Footnote 12 to the statements. 4. Childs was unable to perform normal accounts receivable confirmation procedures but used alternative procedures to satisfy himself as to the validity of the receivables. 5. Straw Corporation is the defendant in a litigation; the outcome of which is highly uncertain. If the case is settled in favor of the plaintiff, Straw will be required to pay a substantial amount of cash, which might require the sale of certain fixed assets. The litigation and the possible effects have been properly disclosed in Footnote II to the financial statements. 6. Straw issued debentures on January 31, 19x0, in the amount of $10 million. The funds obtained from the issuance were used to finance the expansion of plant facilities. The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 19x0. Straw declined to disclose these essential data in the footnotes to the financial statements.

REQUIRED: A. Consider all facts given and rewrite the auditors report in an acceptable and complete format, incorporating any necessary departures from the standard (shortform) report. B. Do not discuss the draft of Childs report but identify and explain any items included in Other Information that need not be part of the auditors report.

Case 4
March Corporation, an audit client of yours, is a manufacturer of consumer products and has several wholly owned subsidiaries in foreign countries that are audited by other independent auditors in those countries. The financial statements of all subsidiaries were properly consolidated in the financial statements of the parent company and the foreign auditors reports were furnished to your CPA firm. You are now preparing your auditors opinion on the consolidated balance sheet and statement of income and retained earnings for the year ended June 30, 1992. These statements were prepared on a comparative basis with those of last year. 1. How would you evaluate and accept the independence and professional reputations of the foreign auditors? 2. Under what circumstances may a principal auditor assume responsibility for the work of another auditor to the same extent as if the principal auditor had performed the work alone? 3. Assume that both last year and this year you were willing to utilize the reports of the other independent auditors in expressing your opinion on the consolidated financial statements but were unwilling to take full responsibility for performance of the work underlying their opinions. Assuming your examination of the parent companys financial statements would allow you to render an unqualified opinion, prepare (1) the necessary disclosure to be contained in the scope paragraph, and (2) the complete opinion paragraph of your auditors report. 4. What modification(s), if any, would be necessary in your auditors opinion if the financial statements for the prior year were unaudited?

Case 5 Standards of Fieldwork

You have accepted the engagement of auditing the financial statements of the Thorne Company, a small manufacturing firm that has been your client for several years. Because you were busy writing the report for another engagement, you sent an assistant accounting to begin the audit with the suggestion that she start with the accounts receivable. Using the prior years working papers as a guide, the assistant prepared a trial balance of the accounts, aged them, prepared and mailed a positive confirmation request, examined underlying support for charges and credits, and performed such other work as she deemed necessary to obtain reasonable assurance about the

validity and collectibility of the receivables. At the conclusion of her work, you reviewed the working papers that she prepared and found that she had carefully followed the prior years working papers. REQUIRED: The opinion rendered by a CPA states that the audit was made in accordance with generally accepted auditing standards. List the three generally accepted auditing standards of fieldwork. Relate them to the above illustration by indicating how they were fulfilled or, if appropriate, how they were not fulfilled.

Case 6 Disclosure Dilemma

The Roberts-On Ringer Corporation, a conglomerate, acquired the Granof Grain Storage Company in 1983. Unbeknown to Roberts-Ons management, Granof Grain executives had engaged in illegal price-fixing activities during the period 1966-1982. In 1984, one of those executives died and curiously included in his last will and testament a full accounting of the illegal activities. The president of Roberts-On, in a moment of indiscretion, allowed the auditor (you) to see a copy of this document. Thus, you have full knowledge of the situation. With regard to matters of timing, you are auditing the financial statements for the year ended December 31, 1994, and plan to complete the fieldwork and write the report on February 15, 1985. It is now January 28, 1985. The will and testament will be read in open probate court on February 28. Assume that the statute of limitations, which will bar lawsuit action, runs out on February 20. In other words, after February 20 no prosecution can take place. As you begin to complete the fieldwork and write your report, you realize that you and the president know the facts. Fourteen other Granof executives also know, but they have remained silent. The customers of Granof are apparently unaware of the price-fixing situation in 19661982. Roberts total assets amount to $1 billion, stockholders equity is $300 million, and net current assets amount to $100 billion. Treble damages that could arise from this kind of violation are conservatively estimable at $150 million. The president of Roberts-On has implored you to forget having seen the documents. REQUIRED: a. Discuss the ethical and technical decision problems the auditor faces in this situation. b. What should the auditor do? Why? c. What may be the consequences of the auditors decision(s)? Explain.

Case 7 Responsibility for Fraud

Herbert McCoy is the chief executive officer of McCoy Forging Corporation, a small but rapidly growing manufacturing company. For the past several years, Donovan & Company, CPAs have been engaged to do compilation work and a systems improvement study and to prepare the companys federal and state income tax returns. In 19x1, McCoy decided that due to the growth of the company and requests from bankers, it would be desirable to have an audit. Moreover, McCoy had recently received a disturbing anonymous letter that stated: Beware! You have a 4

viper in your nest. The money is literally disappearing before your very eyes! Signed: A friend. McCoy believed that the audit was entirely necessary and easily justifiable on the basis of the growth and credit factors mentioned above. He decided he would keep the anonymous letter to himself. Therefore, McCoy, on behalf of McCoy Forging, engaged Donovan & Company, CPAs to render an opinion on the financial statements for the year ended June 20, 19x2. He told Donovan he wanted to verify that the financial statements were accurate and proper. He did not mention the anonymous letter. The usual engagement letter providing for an audit in accordance with generally accepted auditing standards (GAAS) was drafted by Donovan & Company and signed by both parties. The audit was performed in accordance with GAAS. The audit did not reveal a clever defalcation plan by which Harper, the assistant treasurer, was siphoning off substantial amounts of McCoy Forgings money. The defalcations occurred both before and after the audit. Harpers embezzlement was discovered in October 19x2. Although the scheme was fairly sophisticated, it could have been detected had additional checks and procedures been performed by Donovan & Company. McCoy Forging demands reimbursement from Donovan for the entire amount of the embezzlement, some $20,000 of which occurred before the audit and $25,000 after. Donovan has denied any liability and refuses to pay. REQUIRED Answer the following, setting forth reasons for any conclusions stated: a. In the event McCoy Forging sues Donovan & Company, will it prevail in whole or in part? b. Might there be any liability to McCoy Forging on McCoys part, and if so, under what theory?

Case 8
Tammy Potter, a new partner with the regional CPA firm of Tower & Tower, was recently appointed to the board of directors of a local civic organization. The chairman of the board of the civic organization is Lewis Edmond, who is also the owner of a real estate development firm, Tierra Corporation. Potter was quite excited when Edmond indicated that his corporation needed an audit, and he wished to discuss the matter with her. During the discussion, Potter was told that Tierra Corporation needed the audit to obtain a substantial amount of additional financing to acquire another company. Presently, Tierra Corporate is successful, profitable, and committed to growth. The audit fee for the engagement should be substantial. Since Tierra Corporation appeared to be a good client prospect, Potter tentatively indicated that Tower and Tower wanted to do the work. Potter then mentioned that Tower & Towers quality control policies require an investigation of new clients and approval by the managing partner, Lee Tower.

Potter obtained the authorization of Edmond to make the necessary inquiries for the new client investigation. Edmond was found to be a highly respected member of the community. Also, Tierra Corporation was highly regarded by its banker and its attorney, and the Dun and Bradstreet report on the corporation reflected nothing negative. As a final part of the investigation process, Potter contacted Edmonds former tax accountant, Bill Turner. Potter was surprised to discover that Turner did not share the others high opinion of Edmond. Turner related that on an IRS audit 10 years ago, Edmond was questioned about the details of a large capital loss reported on the sale of a tract of land to a trust. Edmond told the IRS agent that he had lost all of the supporting documentation for the transaction, and that he had no way of finding out the names of the principals of the trust. A search by an IRS auditor revealed that the land was recorded in the name of Edmonds married daughter and that Edmond himself was listed as the trustee. The IRS disallowed the loss and Edmond was assessed a civil fraud penalty. Potter was concerned about these findings, but eventually concluded that Edmond had probably matured to a point where he would not engage in such activities. REQUIRED: a. Present arguments supporting a decision to accept Tierra Corporation as an audit client. b. Present arguments supporting a decision not to accept Tierra Corporation as an audit client. c. Assuming that you are Lee Tower, set forth your decision regarding acceptance of the client, identifying those arguments from parts (a) or (b) that you found most persuasive.

Case 9 Preparation of Working Papers

An important part of every audit of financial statements is the preparation of audit working papers. REQUIRED: a. Discuss the relationship of audit working papers to each of the standards of fieldwork. b. You are instructing an inexperienced staff member, Lee Colquitt, on his first auditing assignment. He is to examine the client for inclusion in the audit working papers. Prepare a list of the comments, commentaries, and notations that Colquitt should make or have made on the account analysis to provide an adequate working paper as evidence of the audit. (Do not include a description of auditing producers applicable to the account.)

Case 10
The third generally accepted auditing standard of fieldwork requires that the auditor obtain sufficient competent evidential matter to afford a reasonable basis for an opinion regarding the financial statements under examination. In considering what constitutes sufficient competent evidential matter, a distinction should be made between underlying accounting data and all corroborating information available to the auditor.

a. Discuss the nature of evidential matter to be considered by the auditor in terms of the underlying accounting data, all corroborating information available to the auditor, and the methods by which the auditor tests or gathers competent evidential matter. b. State the three general presumptions that can be made about the validity of evidential matter with respect to comparative assurance, persuasiveness, and reliability.

Case 11
The city of Lauraville recently opened a private parking lot in its downtown area for the benefit of city residents. A guard has been hired to patrol the lot and to issue pre-numbered parking stickers to residents submitting an application form and showing evidence of residency. When the sticker is affixed to a car, the resident may park in the lot for twelve hours by placing four quarters in the parking meter. The guard not only inspects the stickers on all parked cars to determine that only residents are parking in the lot, but also looks at the time gauges to see that the necessary fee has been paid. The completed application forms are maintained in the guards office. By using a master key, the guard takes coins from the meters weekly and places them in a locked collection box. The guard delivers the box to the city storage department, where a clerk opens it, manually counts the coins, puts the cash in a safe, and records the total on a weekly cash report. This report is sent to the citys accounting department. The day following the cash count, the city treasurer picks up the cash and manually recounts it, prepares the deposit slip, and makes the deposit at the bank. The deposit slip, authenticated by a bank teller, is sent to the accounting department, where it is filed with the weekly cash report. Describe weaknesses in this system, and for each weakness recommend at least one improvement to strengthen control procedures.

Case 12
All user department requests for program modifications at Ideal Controls, Inc. are submitted to data processing on a program change request form. These forms are logged on receipt by data processing and assigned a sequential control number. Before the request form is sent to data processing by the user department, the manager of the user department approves the modification request. Data processing will not accept or log a modification request without a user department managers signature. The data processing clerk receiving and logging the modification requests distributes them to the responsible programmer. The programmer then obtains the production program documentation binder and a copy of the source version of the program from the production library, makes the coding changes, and tests the modified program. Test results are reviewed with the requesting user and a formal approval of the test results is obtained from the user. The programmer uses the formal approval of the test results as authorization to have the modified program put into production. Placing the program into production is the responsibility of a production library control clerk. This clerk receives a copy of the user approval of the test results and the source version of the modified version of the sour program and places the

resulting object program on the production library. A form is sent to the user department notifying it when the modified program will begin to be used as part of normal production. A copy of this form is returned to the clerk who originally logged the request and that clerk notes the request is completed. REQUIRED: a. What control weaknesses, if any, may be present in this situation? b. What are the ramifications of any weaknesses noted? c. To what degree may the auditor place reliance on the program modification procedure?

Case 13 Use of Computer-Assisted Audit Techniques

After determining that computer controls are valid, Howard Hastings, CPA, is reviewing the sales system of Rosco Corporation to determine how a computerized audit program may be used to assist in performing tests of Roscos sales records. Rosco sells crude oil from one central location. All orders are received by mail and indicate the pre-assigned customer identification number, desired quantity, proposed delivery date, method of payment, and shipping terms. Because prices fluctuate daily, orders do not indicate a price. Price sheets are printed daily and details are stored in a permanent disk file. The details of orders are also maintained in a permanent disk file. Each morning the shipping clerk receives a computer printout that indicates details of customers orders to be shipped that day. After the orders have been shipped, the shipping details are entered in the computer, which simultaneously updates the sales journal, perpetual inventory records, accounts receivable, and sales accounts. The details of all transactions, as well as daily updates, are maintained on disks available for use by Hastings in the performance of the audit. REQUIRED: a. How may Hastings use a computerized audit program to perform substantive tests of Roscos sales records in their machine-readable form? (Do not discuss accounts receivable or inventory.) b. After having performed these tests with the assistance of the computer, what other auditing procedures should Hastings perform in order to complete the examination of Roscos sales records?

Case 14 Generalized Audit Software Package

An auditor is conducting an audit of the financial statements of a wholesale cosmetics distributor with an inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution center and in two public warehouses. An inventory computer

file is maintained on a computer disk and at the end of each business day, the file is updated. Each record of the inventory file contains the following data: Item number Location of item Description of item Quantity on hand Cost per item Date of last purchase Date of last sale Quantity sold during year

The auditor is planning to observe the distributors physical count of inventories as of a given date. The auditor will have available a computer tape of the data on the inventory file on the date of the physical count and a general-purpose computer software package. REQUIRED: The auditor is planning to perform basic inventory auditing procedures. Identify these procedures and describe how the use of the generalized audit software package and the tape on the inventory file data might be helpful to the auditor in performing such auditing procedures. Basic inventory auditing procedure How general-purpose computer software package and tape of the inventory file data might be helpful Determining which items are to be test-counted by selecting a random sample of a representative number of items from the inventory files as of the date of the physical count.

1. Observe the physical count, making and recording test counts where applicable.

Case 15 Definition of Audit Sampling

Jane Meryl, CPA, is examining fixed asset additions in the audit of Wallachs Manufacturing. The fixed asset additions total $2 million. She is primarily concerned with overstatements. In analyzing the additions, she determines that five additions pertain to a plant expansion program. They total $1.6 million. Four hundred other smaller additions account for the remaining $400,000 book value. Meryl decides that the five large additions are individually significant and need to be examined 100%. Assume that she has applied the following audit strategies to the remaining 400 items. Strategy 1 Meryl has performed other procedures related to fixed asset additions, including: 1. assessing control risk for fixed assets assertions, which supported a low assessed control risk, 9

2. a review of entries to the fixed asset ledger, which revealed no unusual items, and 3. an analytical procedure that suggests that the $400,000 book value of the 400 smaller additions is consistent with the trend for prior years. Strategy 2 Meryl has not performed any procedures related to the remaining 400 items, but she has decided that any misstatements in those items would be immaterial. Strategy 3 Meryl and Wallachs have agreed that the fixed asset additions contain numerous errors, therefore, Meryl takes a sample of the 400 smaller additions to estimate the total. Wallachs has indicated that they will record her estimate plus the total of the five large additions as their book value. REQUIRED: Discuss each of the above strategies in terms of whether SAS No. 39, Audit Sampling, governs the application.

Case 16
Martha Smith, CPA, is planning to use mean-per-unit sampling for variables in performing a substantive test of details on inventory records of her client, Octave Corporation. Martha has obtained the clients inventory listing, which shows each inventory item in stock, its serial number, and its value. The listing includes 6,234 items. It shows a total of $5,483,600, the balance in Octaves general ledger inventory account. As a first step, Martha estimates the standard deviation of the population of inventory item values. Her estimate is $148. Next, she concludes that tolerable error for the test is $225,000. Finally, she decides the risk of incorrect acceptance should be 10 percent; the risk of incorrect rejection, 20 percent. REQUIRED: a. Determine the allowance for sampling risk to be used in calculating sample size. b. Calculate the required sample size for this test. c. Discuss methods Martha might use to select the sample for this test. d. Assume that once the sample is selected and appropriate auditing procedures applied to the sample items. The aggregate audited value of the sample items is $97,350. Also assume the standard deviation of the sample items is $142. Determine the estimated value of the population and the allowance for sample risk actually achieved. e. What audit conclusions may Martha draw from results of the test?

Case 17 Audit Hypothesis Testing

Eileen Cooper, CPA, is auditing Axline Corporations inventory. The inventory is recorded on Axlines balance sheet at $1,000,000. It consists of 12,500 kinds of items of approximately equal value. There are no identifiable dollar value strats. Axline does not use perpetual


inventory unit records but does have a well-planned inventory taking and counting operation. Axline uses two count teams with the supervision of counting in each department performed by a member of the internal audit department. Axline shuts down plant operations for inventorytaking purposes. Based on (1) compliance test counting, (2) observation to ascertain that inventory-taking instructions are followed, and (3) evaluation of the competence and carefulness of client personnel taking inventory. Cooper decides that internal accounting control risk (IC) is no more than 20%. Cooper concludes that the inventory valuation of $1,000,000 will be acceptable if she can be 95% confident that the actual inventory is within $50,000 of the valuation. The statistical test will consist of recounting, repricing, and extending each sample item selected. Other audit procedures (AR) consist of inventory turnover calculations, comparison with prior years, and cutoff tests to ensure that purchases and sales are reflected inventory in the proper accounting period. Coopers best guess is that these other procedures have an 80% risk. (Remember that AR represents the auditors judgment concerning the risk that such procedures would fail to detect a material monetary error if it existed in the account.) Having completed the internal accounting control analysis and evaluation of Axlines inventorytaking procedures, Cooper begins her substantive test planning. To estimate the standard deviation, she takes a pilot sample of 30 inventory lines. The standard deviation that results from the pilot sample is $25. REQUIRED: a. What is the risk of incorrect rejection? b. What is the risk of incorrect acceptance (assume that audit risk is 5%)? c. What is the amount of tolerable error? d. Calculate desired precision. e. Calculate sample size. f. Assuming that a sample size of 256 is used, and that the standard deviation of the 256 sampled items is $28, calculate the standard error of the mean. g. Calculate achieved precision. h. If the mean of the 256 sampled items is $81, calculate the dollar value estimate of the total inventory. i. Does the statistical test support Axlines inventory valuation? j. If the statistical test did not support the inventory valuation, what action should Cooper take?

Case 18
In the audit of Potomac Mills, the auditors wish to test the costs assigned to manufactured goods. During the year, the company has produced 2,000 production lots with a total recorded cost of $5.9 million. The auditors select a sample of 200 production lots with an aggregate book value of $600,000 and vouch the assigned costs to the supporting documentation. Their examination 11

discloses errors, in the cost of 52 of the 200 production lots; after adjustment for these errors, the audited value of the sample is $582,000. REQUIRED: a. Show how the auditors would compute an estimate of the total cost of production lots manufactured during the year using each of the following sampling plans. (Do not compute the precision or reliability of these estimates.) (1) (2) (3) Mean-per-unit estimation Ratio estimation Difference estimation

b. Explain why mean-per-unit estimation results in a higher estimate of the population value than does ratio estimation in this particular instance.

Case 19
You are now conducting your third annual audit of the financial statements of Elite Corporation for the year ended December 31, 1987. You decide to employ unrestricted random number statistical sampling techniques in testing the effectiveness of the companys internal control procedures relating to sales invoices, which are all serially numbered. In prior years, after selecting one representative two-week period during the year, you tested all invoices issued during that period and resolved to your satisfaction all of the errors that were found. REQUIRED: a. Explain the statistical procedures you would use to determine the size of the sample of sales invoices to be examined. b. One the sample size has been determined, how would you select the individual invoices to be included in the sample? Explain. c. Would the use of statistical sampling procedures improve the examination of sales invoices as compared with the selection procedure used in prior years? Discuss. d. Assume that the company issued 50,000 sales invoices during the year and the auditor specified a confidence level of 95 percent with a precision range of plus or minus 2 percent. (1) Does this mean that the auditor would be willing to accept the reliability of the sales invoice date if errors are found on no more than 4 sales invoices out of every 95 invoices examined? (2) If the auditor specified a precision range of plus or minus 1 percent, would the confidence level be higher or lower than 95 percent, assuming that the size of the sample remains consent? Why?

Case 20 Subsequent Events

Dudwin, Inc. is preparing its annual financial statements and annual report to stockholders. Management wants to be sure that all of the necessary and proper disclosures are incorporated 12

into the financial statements and the annual report. Two classes of items that have an important bearing on the financial statements are subsequent events and contingent liabilities. The financial statements could be materially inaccurate or misleading if proper disclosure is not made. REQUIRED: a. Define what is meant by a subsequent event, identify the two types of subsequent events, and explain the appropriate statement presentation of each type. b. Identify the essential elements of a contingent liability and explain how a contingent liability should be discussed in the financial statements. c. Explain how a subsequent event may relate to a contingent liability. Give an example to support your answer.

Case 21 Subsequent Events

You are in the process of winding up the fieldwork on XYZ Stove Corporation, a company engaged in the manufacture and sale of kerosene space heating stoves. To date there has been every indication that the financial statements of the client present fairly the position of the company at December 31, and the results of its operations for the year then ended. The company had total assets at December 31 of $4 million and a net profit for the year (after deducting federal and state income tax provisions) of $285,000. The principal records of the company are a general ledger, cash receipts record, voucher register, sales register, check register, and general journal. Financial statements are prepared monthly. Your fieldwork will be completed on February 20, and you plan to deliver the report to the client by March 12. REQUIRED: a. Prepare a brief statement about the purpose and period to be covered in a review of subsequent events. b. Outline the post-audit review program you would follow to determine what transactions involving material amounts, if any, have occurred since the balance sheet date.

Case 22 Use of Other Auditors

Meridian Corporation, an audit client of Tim Cantey, CPA, is a manufacturer of consumer products, and has several wholly owned subsidiaries in foreign countries that are audited by other independent auditors in those countries. The financial statements of all subsidiaries were properly consolidated in the financial statements of the parent company and the foreign auditors reports were furnished to Cantey. Cantey is now preparing the auditors opinion on the consolidated balance sheet, statement of income, retained earnings, and cash flows for the year ended June 30, 19x1. These statements were prepared on a comparative basis with those of last year.


REQUIRED: a. How should Cantey evaluate and accept the independence and professional reputations of the foreign auditors? b. Under what circumstances may Cantey assume responsibility for the work of another auditor to the same extent as if Cantey had performed the work alone? c. Assume that both last year and this year Cantey was willing to use the reports of the other independent auditors in expressing an opinion on the consolidated financial statements but was unwilling to take full responsibility for performance of the work underlying their opinions. Assuming Canteys audit of the parent company financial statements would allow him to render an unqualified opinion and prepare (1) the necessary disclosure to be contained in the opening paragraph and (2) the complete opinion paragraph of the auditors report.

Case 23 Internal versus External Auditing

Delta Machine Company is considering developing an internal audit department. A few years ago, the company began an expansion program that included the acquisition of new businesses, some of which are distant from the home office. Delta has used the acquired managements in most past acquisitions and expects to continue to do so. The corporate organization is decentralized, with the parent company (Delta Machine) setting the general policy. Divisions and subsidiary managements are quite autonomous; their performance is measured against budgets and return on investment targets established at the beginning of each year. The units of Delta manufacture and market their own products. The present company-wide-volume is $150,000,000. Delta Machine has been audited by the CPA firm in which you are a manager. You have supervised the audit of Delta for the past three years. You have been asked by Delta to prepare a report on the activities that could be undertaken by an internal audit department. REQUIRED: a. Prepare a report that describes: (1) the different objectives of the external versus internal auditor. (2) the types of audits that an internal audit department might be expected to perform. b. The company has indicated that you will be asked to head the internal audit department if it is established. Describe the change(s) in your audit philosophy and changes in your relationship to the firm management, if any, you believe should occur if you were to take this job.

Case 24
The Jameson Company produces a variety of chemical products for plastics manufacturers. The plant works on two shifts, five days per week, with maintenance work performed on the third shift and on other days as required. An audit the staff conducted of the new corporate internal audit department has be completed recently, and the comments on inventory control were not 14

favorable. Audit comments were particularly directed to the control of raw materials ingredients and maintenance materials. Raw materials ingredients are received at the back of the plant, signed for by one the employees of the batching department, and stored near the location of the initial batching process. Receiving tallies are given to the supervisor during the day, and he, forwards the tallies to the inventory control department at the end of the day. The inventory control department calculates ingredient usage from weekly reports of actual production and standard formulas. Physical inventories are taken quarterly. The inventory control department prepares purchase requisitions, and rush orders are frequent. Despite the need for rush orders, the production superintendent regularly gets memos from the controller stating that excess inventory must exist because the ingredients inventory dollar value is too high. Maintenance parts and supplies are received and stored in a storeroom. A storeroom clerk works each of the operating shifts. Storeroom requisitions are to be filled out for everything taken from the storeroom; however, this practice is not always followed. The storeroom is not locked when the clerk is out because of the need to get parts quickly. The storeroom is also open during the third shift for the maintenance crews I get parts as needed. The storeroom clerk prepares the purchase requisitions, and physical inventory is taken on a cycle count basis. Rush orders are frequent. REQUIRED: a. Identify the deficiencies in Jameson Company's internal controls for (1) ingredients inventory, and (2) maintenance materials and supplies inventory. Recommend improvements for each of these areas. b. What procedures would the internal auditors use to identify the deficiencies in Jameson Company's inventory control?

Case 25
Cesnik & Horn, CPAs, were accountants for Duldick, a closely held corporation. Cesnik & Horn had been previously engaged by Duldick to perform compilation services. Brin, Duldicks president, indicated something more than the previous type of service was needed. Brin explained to Cesnik, the partner in charge, that the financial statements would be used internally, primarily for management purposes, as well as to obtain short-term loans from financial institutions. Cesnik recommended that a review of the financial statements be performed. An engagement letter was not prepared. While conducting the review, Cesnik expressed reservations about the statements. At several stages Cesnik commented that certain figures and conclusions appear unusual, but it is best to take the clients work about the validate of certain entries, since the review is primarily for internal use and is not an audit. Cesnik & Horn did not discover a material act of fraud committed by Duldicks management. However, fraud would have been detected had Cesnik not relied wholly on managements representations concerning the validity of certain entries that were noticed and appeared unusual.


a. What role does the engagement letter play when a CPA has agreed to perform a review of a closely held company? What points would be relevant and should be covered in a typical engagement letter, given the parties and facts described above? b. What is the duty of the CPA when suspicious circumstances are revealed by a review? Give reasons for your conclusion. c. What potential liability does Cesnik & Horn face, and who may assert claims against the firm? Give reasons for your conclusions.