Professional Documents
Culture Documents
Auditing Cases
SOLUTIONS MANUAL 11e
Table of Contents
Introductory Case
6
Case 1 13
Case 2 21
Case 3 29
Case 4 39
Case 5 51
Case 6 67
Case 7 74
Case 8 83
Case 9 92
Case 10 100
Case 11 105
Case 12 115
Case 13 127
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A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS
The Lakeside Company: Auditing Cases, 11th edition, has been updated
in light of the accounting scandals of the early 2000s and the passage of
the Sarbanes-Oxley Act of 2002, and the renewed interest in ethics
within the accounting and auditing profession.
Ethics questions are now specifically identified with an ethics logo. The
ethics questions are often open ended, and this solutions manual does
not try to give exact answers to these questions. Rather, we intend to
give some ideas for classroom discussion, and to help with student
research on these questions.
(Intr-1) The case states that the firm of Abernethy and Chapman is
considering the acceptance of clients that are publicly traded.
What specific steps would the firm have to take before they could
accept an audit client that is publicly traded? Objective – Initial
PCAOB registration.
1
acceptance in the PCAOB and in this case the effect of an initial
public client.
(4-2) Discuss the assessment of control risk for audit clients that are
public companies. If Lakeside were to become a public company,
what impact would that have on Abernethy and Chapman's
assessment of Lakeside's control risk and the evaluation of
internal control? Objective – Internal control both in the public
reporting context. Section 404 audits.
2
(7-1) The case assumes that tests of controls have been completed and
substantive testing in the payroll area has commenced. During the
internal control evaluation and testing what options are available to the
CPA to document problems and communicate their effect? Write a
sample of a “material weakness” in the area of payroll internal control that
would be included in the auditor's report. Objective – Material
weakness example.
3
A NOTE ON RESEARCH ASSIGNMENTS
- To provide a means for improving the writing skills of students. From all
reports, accounting majors too often leave college lacking in the basic
ability to compose and construct sentences and paragraphs. Accounting
and auditing (especially as one moves up in an organization) obviously
require skills other than the purely quantitative. Memos, reports,
footnotes, audit and accounting guides, etc., all require accountants and
auditors to be effective communicators of the written word. Indeed, the
instructor may want to team up with a member of the school's English or
communications department to enhance the effectiveness of these
assignments. The auditing instructor can then evaluate the technical and
research portions of the assignment, while the English instructor would
make suggestions as to grammar, syntax, construction of sentences and
paragraphs, logic of the thought process, etc. As a preliminary step, the
instructor may want to assign articles such as "Word Crunching: A Primer
for Accountants" from the March 1990 issue of the Journal of
Accountancy.
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decision.
5
INTRODUCTORY CASE
(1)
The staff auditor performs many of the detailed audit procedures, such as
preparing and controlling accounts receivable confirmations. In general the work
of the staff auditor is controlled by audit program and supervised by the senior
auditor
The senior auditor coordinates the audit at the client's location and performs
many of the more difficult audit procedures, such as analytical review
procedures. Usually the detailed work performed by the audit senior is more
sophisticated and requires the experience gained by someone holding that rank.
The audit senior is supervised by the manager.
The manager and the partner have supervisory roles. Managers and partners
often have more than one audit team under supervision at any given time.
The partner is the person who has responsibility for determining whether the
firm’s signature can be attached to audit report.
(2)
(3)
An accounting firm is a business like any other, and its management must
recognize that a marketing strategy is probably necessary to generate a
continual flow of sufficient operating revenues. However, in the accounting
profession, disagreement exists as to the extent that such marketing should take.
In the past, overt marketing was not permitted since it was considered to be
unprofessional. This position was supported based on the reasoning that a firm
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should be selected based solely on the quality of its service. No reliable system
existed, though, for conveying such information to potential clients. Hence, firms
with many clients tended to remain large, while smaller firms often found growth
to be nearly impossible. In the free market system espoused by the United
States, restrictions on such practices as advertising and solicitation were
inevitably overturned. Over the past three decades, attitudes toward marketing
have changed dramatically as competition has become much more intense.
Advertisements by CPA firms in newspapers and magazines are now common.
Newsletters such as that distributed by Abernethy and Chapman are also
frequently used to increase a firm's name recognition in the business community.
(4)
- The larger firm may be interested in moving into this geographical region,
and buying the local firm will provide an instant base on which to build a
practice in the area.
- The larger firm may already have an office in this location and feels that
combining the practices will reduce expenses.
Abernethy and Chapman might have several reasons for viewing an acquisition
in a favorable light:
7
- Frequently, the purchase price will be a considerable amount of money
because of the goodwill inherent in an established accounting firm. The
offer to sell may be especially tempting if the partners are nearing
retirement age and the future of the firm appears uncertain.
- The smaller firm may have trouble dealing with increased competition from
bigger firms. Often clients may decide that a change to a nationally known
CPA firm should be made to add extra stature to the audit report. If a local
organization has only a few large clients, it cannot economically afford to
lose a significant amount of revenue in this way. A merger may help the
firm to keep its clients.
- The regional firm may also desire the additional backup services offered by
large organizations. National CPA firms usually have experts in many
industries as well as in specific audit areas who are available for
consultation. In a smaller firm, this degree of assistance is not always
available when a difficult accounting or auditing problem is encountered.
Many mergers have occurred in the auditing profession during recent years.
Critics assert that this trend has reduced competition and will inevitably lead to a
decrease in audit quality. Proponents counter by stating that mergers lead to
more efficient operations and, thus, improve audit quality. Obviously, mergers
will create a drastic change in the profession as more of the smaller firms
disappear. Audit work in this country may possibly become concentrated within
the largest CPA firms. Whether this result is good for the auditing profession
may be merely a question of perspective. To the smaller firms struggling to
survive and grow, the mergers are usually considered a threat as the bigger firms
become more competitive. To the larger firms, the chance for continued growth
and more efficient operations is always an important objective.
See the Sarbanes-Oxley section below for a follow up question related to the
impact of SOX on the auditing profession.
(5)
Moving staff from one area of a CPA firm to another can cause the perception of
an independence problem. For example, the appearance of independence may
be in question if a member of the consulting staff helps to install a new
accounting system for a client and then she moves to the audit staff to audit this
same client.
8
the impact of SOX, in particular the list of proscribed activities for registered CPA
firms.
(1)
The question requires students to address all the elements of a quality control
system, as included in Statement on Quality Control Standards No. 2. In some
cases, students should recognize the need for additional information.
The firm hires only college graduates with a major in accounting and requires
that each professional sit for the CPA exam with one year of employment. This
seems to be a more than adequate quality control procedure. In fact, many firms
hire professionals, such as computer experts, who were not accounting majors.
The firm requires 40 hours of continuing education per year; however, the case
does not address the issue of the type of education (e.g., accounting and
auditing versus other courses). Many states require that a minimum number of
continuing professional education hours be in accounting- and auditing-related
courses.
9
standards and regulatory requirements. This helps to ensure objectivity, as the
consulting auditor is not a direct part of the engagement. The firm should have a
mechanism for consultation with authoritative literature and other sources,
including outside experts, if its professional staff lacks expertise in a particular
area.
The firm seems to have a clear chain of command and adequate supervision on
the audit. The staff auditors report to the senior auditor, who in turn reports to
the manager. The partner-in-charge has an overall supervisory position.
-Acceptance and Continuation of Clients and Engagements: This case does not
address this control standard. It does note that the firm is attempting to gain
more clients through an extensive marketing program. It is important to have
many controls when considering a potential client, so that the potential risks of
legal exposure are not too great. (Note: This topic is addressed in Case 2.)
-Monitoring: The firm has a partner, DeAnna Malott, assigned to monitor the
quality control standards. The case does not mention what types of documents
are required to support these controls, but documentation is extremely important.
For example, many firms require employees to submit a listing of all financial ties
to companies so that the firm can monitor its independence.
(1)
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- Inspection - The PCAOB operates a system of inspections and
publicizes the results, per its authority under the SOX act:
It shall be "unlawful" for a registered public accounting firm to provide any non-
audit service to an issuer contemporaneously with the audit, including: (1)
bookkeeping or other services related to the accounting records or financial
statements of the audit client; (2) financial information systems design and
implementation; (3) appraisal or valuation services, fairness opinions, or
contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing
services; (6) management functions or human resources; (7) broker or dealer,
investment adviser, or investment banking services; (8) legal services and expert
services unrelated to the audit; (9) any other service that the Board determines,
by regulation, is impermissible. The Board may, on a case-by-case basis, exempt
from these prohibitions any person, issuer, public accounting firm, or transaction,
subject to review by the Commission.
It will not be unlawful to provide other non-audit services if they are pre-approved
by the audit committee in the following manner. The bill allows an accounting firm
to "engage in any non-audit service, including tax services," that is not listed
above, only if the activity is pre-approved by the audit committee of the issuer.
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The audit committee will disclose to investors in periodic reports its decision to
pre-approve non-audit services. Statutory insurance company regulatory audits
are treated as an audit service, and thus do not require pre-approval.
- Partner rotation- The rotation of the lead partner and the reviewing
partners are required by the SOX act.
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CASE 1
(1)
Outside parties are aware that the financial information produced by a company
and its management may not always be reliable. Hence, to add credibility to this
reporting process, independent experts are retained to audit the financial
statements and test the underlying accounting records. These auditors then
issue an opinion for the benefit of outside parties as to the fair presentation of the
financial statements in conformity with generally accepted accounting principles.
This added degree of assuredness allows decision-makers to rely on reported
financial information.
(2)
Each industry may have its own specific accounting practices. In addition,
certain industries frequently offer unique auditing problems. Thus, without a
thorough investigation, the auditor cannot ascertain the knowledge that will be
needed in examining a potential client. In the consumer electronics business, for
example, the methods of distribution as well as credit policies would be
significantly different from those found in a car dealership. Damaged or obsolete
inventory are other problems that might be more important in this specific
industry. Hence, a knowledge of one type of operation does not necessarily
mean that the auditor has the expertise needed to examine a client operating in a
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different industry.
Auditing standards require that auditor have the expertise by the completion of
the audit, but this expertise need not be in place at the beginning. It would be
unethical to misrepresent a firm’s experience, but it need not be volunteered.
(3)
(4)
Critics of the auditing profession have argued vehemently for a number of years
that advisory services such as those discussed in this question taint the
appearance (and possibly the reality) of independence. These services may
appear to the public to give the audit firm a financial interest in the success of the
company. This argument holds that the firm will now want the client to succeed
as proof of the quality of the advice that was given. In addition, the audit team
may be less judicious in investigating these systems since they are aware that
members of their own firm designed and installed them.
Audit firms counter by stating that adequate safeguards have been put into place
to ensure continued independence. For example, advisory services are
frequently rendered by a separate division of the firm so that no proximity exists
between this function and the audit staff. In addition, firms are not allowed to
give many types of advice that might jeopardize their independence. Finally,
audit firms must make certain that their services are limited to making
recommendations, not carrying out management decisions. The firm cannot
make decisions for the client.
14
Sarbanes-Oxley specifically proscribes various activities that have traditionally
been part of the CPA’s repertoire. Design of accounting systems is prohibited,
although helping a client with selection and implementation of off-the-shelf
packages would be acceptable. So, in this case, it depends on what the client
means by “developing.” In the event the Lakeside goes forward with its public
offering Abernathy and Chapman will need to decide whether to remain
independent so they can continue as Lakeside’s auditor, or sacrifice
independence to do systems consulting. Sarbanes-Oxley prevents trying to do
both.
(5)
* Discuss with client the policy for valuing inventory and identifying obsolete
inventory items.
* Discuss with client the procedures for obtaining a proper year-end cut-off.
15
* Review depreciation schedules, and recalculate a sample of the
depreciation expense figures.
(6) A company may not want its CPAs to audit a client's records because the
auditors gain a substantial amount of competitive information during an
audit. However, CPAs are bound by confidentiality under the AICPA's
Code of Professional Conduct. Also, a CPA's knowledge of the industry
gained from having several clients in the same industry provides him or
her with insights he/she may not have otherwise had.
(1)
(a) and (b) The independent auditor must be able to review massive quantities of
information and identify the fraud risk factors that may affect the amount of
evidence to be gathered or the opinion to be rendered. This question calls upon
the judgment abilities of the students. The format used by students for this
memo is not important as long as it is clear and understandable. SAS 99 requires
use a brainstorming session in the planning stage to be sure that everyone
associated with the audit understands the nature of the business and the
potential risk of fraud. These sessions can also occur during the audit if
additional evidence presents itself. Potential problems that students would be
expected to identify are as follows:
* Internal Control - The president of the company admits that the company's
internal control is antiquated. Control problems may be heightened in that
operations extend throughout two states. Since understanding the internal
control is one of the prerequisites for ultimately determining the amount of
substantive testing that will be required, the weakness of the various
controls may require the extensive gathering of evidence, or even
preclude an opinion.
16
* Uncertainty Involved with the Sixth Store - A qualified opinion was issued
by the predecessor auditor in connection with this store. Abernethy and
Chapman must face the question as to whether this issue can be resolved
during 2006.
* Distributorship Sales - The case indicates that these sales have risen
dramatically during the past two years. Any sudden change or fluctuation
in an account balance will always warrant the auditor's attention. In this
instance, the auditor will be especially interested in verifying the validity of
these sales figures.
* Related Party Transactions - The case indicates that Lakeside has begun
to have financial dealings with the president of the company. Obviously,
nothing is wrong with this arrangement, but such related party transactions
are often difficult for the auditor to verify. In addition, they require clear
disclosure.
* Rental Agreements - Five of the stores have been leased and, apparently,
Store Seven will be rented from Rogers. Rental agreements pose the
question as to the need for capitalizing the lease. Abernethy and
Chapman will have to read the various agreements to see if any of them
qualify as a capital lease under the criteria established by the Financial
Accounting Standards Board.
17
* Inventory Returns - For distributorship sales, up to 20% of the inventory
items can be returned within four months. As of the end of the year,
Lakeside will have a large contingent liability associated with the inventory
items sold during the last four months. Not only is the potential size of this
liability a problem but the auditor's ability to estimate the amount must be
a concern.
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(2)
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2008, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
19
SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS
(1)
Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934.
Registration with the SEC is required which includes financial reporting. The
laws are summarized at: http://www.sec.gov/about/laws.shtml.
The financial reporting and auditing for public companies has been regulated by
the PCAOB since 2002. The PCAOB registers, inspects and disciplines the
auditors of public companies. Its effect on the public companies is indirect,
through the regulation of the auditors.
Encourage students to visit the SEC EDGAR site to understand the nature of
electronic, public financial information.
(2)
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CASE 2
(1)
The question of materiality is certainly one of the most complex issues in all of
auditing. No clear-cut guidelines have ever been established to aid the auditor in
deciding whether a specific balance or transaction is "material." This lack of an
official standard provides the auditor with the freedom to base all final decisions
on professional judgment. Unfortunately, without a formal rule, the auditor has
little guidance in applying judgment to a particular situation.
Materiality has traditionally been held to be any factor that would influence the
decisions of those parties relying on the financial statements. Identifying a
proper basis of comparison is an important aspect in determining whether an
uncertainty is material. Net income is the most obvious standard of comparison,
although another consideration is which of the statements is affected (e.g.,
Balance Sheet, Income Statement, or both?). The situation questioned by King
and Company involves an investment in fixed assets. Comparing the potential
loss to total assets, investment in stores, and owners' equity would seem a
reasonable basis for judging materiality. Another possible basis is the effect of
the asset write-off on net income.
In the view of the authors, this potential loss (of over $100,000) for a company
with a net worth of only $500,000 would certainly appear to be material. Other
comparisons based on total assets or income would give similar results.
(2)
The CPA firm must talk with the predecessor auditor before accepting the
engagement. The new auditors can learn about the integrity of the potential
client's management as well as about any accounting or auditing problems that
might be encountered. If Rogers prohibits this meeting, Abernethy should
21
carefully explain the necessity of the procedure. The client may not be fully
aware of audit practices and fail to understand that such discussions are a
normal part of investigating new clients. Should the client still insist that no
communication be made with the previous auditor, Abernethy would normally
have to reject the new engagement unless very unusual circumstances
surrounded the client's request.
(3)
The information given by the predecessor auditor as to the integrity of the client's
management must weigh heavily in the decision to seek a new client. Because
of the potential legal liability faced by independent auditors, the decision to
accept a client has become quite important. No auditor wants to perform an
engagement for a company with a management that cannot be trusted.
However, in evaluating the assertions of King and Company, Abernethy must
realize that this firm has just been fired from the Lakeside audit. Some potential
bitterness toward the client is certainly possible. Thus, auditors usually seek
references from other than just the predecessor auditor before deciding whether
to actively pursue a new audit client.
(4)
In a peer review, a team of outside auditors is hired by a CPA firm to review its
system of quality controls, the policies and procedures utilized by that
organization to ensure that its members are following all professional standards -
audit, accounting and review, ethics, etc. This review helps to ensure that the
firm is fulfilling its professional responsibilities. If the peer review team discovers
practices that are unprofessional or inadequate, the firm can make immediate
corrections to rectify the problems.
Peer reviews originated in the 1970s when litigation of CPA firms became
rampant, and congressional investigations of the profession indicated that drastic
improvements were needed. The peer review process was instigated to provide
firms with a means of getting outside consultation about their professional
practices. Rather than discovering problems only after losing a lawsuit, the firms
were periodically reviewed by these outside teams to catch problems before they
grew to be too large.
A peer review team looks at the means by which the public accountant ensures
quality control within its practice. For example, the acceptance of new clients
should be properly monitored by the firm. Adequate consultation needs to be
made available to all staff members so that audit problems can be properly
resolved. Hiring and promotion practices should be established and in place to
provide sufficient staffing for all engagements. The peer review team looks at all
areas of quality control to ascertain that problems do not exist that could lead to
substandard work. In addition, the team reviews the audit documents for a
22
selected number of engagements to see if sufficient, competent evidence is
being gathered and properly documented.
(5)
The permanent file will hold all data about the client that is not anticipated to
change dramatically from year to year. It can be reviewed by the auditor prior to
beginning the engagement to gain insight into the organization of the company.
A permanent file will normally include items such as the articles of incorporation,
organization chart, chart of accounts, contracts, other long-term legal
agreements, and a written description of the company as well as its organization
and history.
The annual working paper ("current") file contains documentation of the evidence
gathered during a specific audit. Thus, the results of confirmations, inquiry,
observations, inspection, calculations, and all other testing are placed within
these audit documents. The contents of this file must substantiate the audit
opinion and also that the auditor followed generally accepted auditing standards
on this particular engagement.
(6)
(7)
The providing of adequate service to a client would always require that the CPA
firm suggest a review rather than an audit whenever it might meet the company's
23
intended objectives. The client must understand, though, that a review is
substantially less than an audit. Procedures are limited primarily to inquiries of
the client's management along with analytical procedures applied to the financial
statements. The report then states that the firm was not aware of any material
modifications to the financial statements that require adjustment to be in
conformity with generally accepted accounting principles (a limited or "negative"
assurance).
In a review, control risk is not assessed, tests of controls are not made, and
adequate substantive testing procedures are not performed on which to base an
opinion as to the fair presentation of the financial statements. Because these
procedures are omitted, a review is less expensive than an audit. However, the
banks and stockholders must be willing to accept the lesser degree of assurance
being provided by the independent auditor. The client should be made aware of
this option but also the potential problems of not having a complete examination.
Of course, if Lakeside pursues the public offering a review will not be adequate.
(8)
Many students may want to reject this engagement based on the internal control
problems, the impairment of value issue, and Rogers' arguments with the
predecessor auditors, but such situations are not uncommon occurrences in
auditing. Public accounting is not a risk-free profession; no perfect audit client
ever exists. Thus, a firm must be able to assess the problems involved and
weigh them against potential rewards. Abernethy and Chapman has an
opportunity here to pick up a new client in a new industry. In addition, Lakeside
has demonstrated the possibility of significant growth in the future. However, the
auditing firm needs to seek some resolution for the uncertainty before becoming
involved. Since that problem is already obvious, an understanding should be
reached with Lakeside prior to beginning the engagement. If this issue can be
successfully resolved, the auditor should seek this new client.
24
SUGGESTED ANSWERS TO EXERCISES
(1)
1. Privately held
2. The basic liability to the client is for losses occurring as a result of any firm
negligence. If Abernethy and Chapman performs the engagement as an
average, prudent auditor would, no problem exists. If not, the client may
sue for return of its audit fee as well as any other resulting losses. A
special problem area exists in the Lakeside case: the client's weak
internal control. Such weaknesses increase the likelihood of fraud or
embezzlement. The control problems also make discovery of such
defalcations more difficult. In addition, proving that the firm is innocent of
negligence is often difficult to do if the client loses money through
defalcations not discovered by the auditor.
5. As a privately held business, this audit does not fall under federal security
laws. Thus, the auditor is bound by common law and is judged under such
precedents as the Ultramares case, the CIT Financial Corp. case, and the
Rusch Factors case. In the Lakeside audit, the CPA firm should have no
liability to third parties unless the audit is performed in a grossly negligent
manner or the firm is negligently responsible for careless financial
misrepresentations. In a few jurisdictions, they may be held liable to
foreseen or foreseeable beneficiaries for ordinary negligence.
25
Answers to Exhibit 2-2:
3. Predecessor auditor stated that the firm was discharged over the wording
of the previous audit opinion.
(2)
The auditor will perform a number of steps in reviewing the audit documents of
the predecessor auditor. The major objective is to examine the types of
information that would be available to an auditor in an ongoing engagement.
Through this review, the auditor can gain satisfaction as to the validity of
beginning account balances as well as accounting principles applied in the
previous audits. By relying on the work of the predecessor auditor, the extensive
review necessary in an initial audit can be held to a minimum.
The audit working paper review should include the following steps:
* Review internal control evaluations for obvious weak areas and for
strengths.
26
* Watch for any problem areas (such as slow collection of accounts
receivable) that were singled out in the previous year.
(3)
This answer assumes that King and Company, the predecessor auditor, has no
reason to believe that their previous report is not still appropriate. Furthermore,
that firm has reviewed the current financial statements and obtained a
representation letter from Abernethy and Chapman, the successor auditor,
stating that the current year's audit has not revealed anything that would have a
material effect on the prior year's audit.
27
INDEPENDENT AUDITOR'S REPORT
To the Stockholders:
28
CASE 3
(1)
The engagement letter is required. Responsibilities of the CPA firm found in the
engagement letter:
(2)
29
should consider each of the following in arriving at an anticipated total:
- Past figures. If cost of goods sold has always been a certain percentage
of Lakeside's sales, that same relationship would be expected to continue
unless other factors have changed. Had Lakeside, for example, switched
from cheaper products to more expensive ones, the relationship between
cost of goods sold and sales would possibly be affected. Or, if Lakeside
has dropped the Cypress line in order to sell the products of some other
manufacturer, a similar change might have been anticipated. However,
without an adjustment of this type, cost of goods sold as a percentage of
sales would be expected to remain stable.
- Industry averages. By studying trade publications, Abernethy and
Chapman can determine an industry average for cost of goods sold as a
percentage of sales. Although Lakeside's results could not be expected to
be exactly the same as this average, the auditors should not anticipate a
significant variation to occur without some adequate explanation.
- Competitors. If available, the financial statements of competing
companies can be used to determine the normal relationship of cost of
goods sold to sales. Although no two companies are ever alike, important
comparisons such as this one should be made between similar
companies.
- Budgeted figures. If Lakeside has an annual budget, the numbers
estimated by the company at the beginning of the period can be used by
the auditor in establishing an expected cost of goods sold.
(3)
- Lakeside has a large amount of debt. The auditor has to ensure that all
debt is being properly reported and disclosed. The interest expense
associated with these liabilities must also be correctly calculated and
recognized. In addition, the auditors need to verify that all loan covenants
30
are being met.
(4)
The auditor must be satisfied that sufficient, competent evidence has been
obtained to substantiate an opinion concerning the fair presentation of the client's
financial statements. The decision as to the sufficiency of this evidence is left
solely to the judgment of the auditor. Only through years of experience can the
auditor develop the ability to make this determination. Although specific
guidelines for this decision are not available, all significant problems must be
resolved and all suspicious occurrences should be investigated. Evidence needs
to be accumulated for each significant area of the financial statements to
substantiate the assertions made by the client about its reported balances.
Where inherent risk and control risk are judged to be high, the auditor must take
steps to reduce detection risk to an acceptable level. In such cases, several
steps are possible: performing additional substantive testing, using more
experienced staff personnel, performing testing procedures closer to the balance
sheet date, or relying on more effective testing procedures.
Another factor that influences the auditor's decision is the quality of evidence
being accumulated. Some information may come directly to the auditors from
outside parties, data that is usually considered to be of a higher quality than
evidence prepared by the client company. Less evidence is required if it is
judged by the auditor to be of a high quality.
Although each of these factors is considered, the ultimate decision still must rest
with the auditor's judgment. This individual is taking responsibility for the audit
opinion as well as accepting the risks involved in circulating this report. Thus, the
auditor must be satisfied that, based upon the wisdom gained through years of
audit experience, sufficient evidence has been obtained.
(5)
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performed by the independent auditor. Furthermore, analytical procedures
provide circumstantial evidence which, taken alone, is not a high quality type of
evidence.
(6)
Since the students may not be familiar with the AICPA Industry Audit Guides, the
instructor may want to bring an example or two to class for this discussion.
Examples of the industries covered by these audit guides include:
- Airlines
- Finance Companies
- Investment Companies
- Providers of Health Care Services
(7)
A number of the current concerns faced by auditing firms as well as the auditing
profession as a whole relate either directly or indirectly to increased price
competition. Through class discussion of this particular question, students should
be able to ascertain at least three of these problems:
32
the auditor will 1) accept less than sufficient evidence, 2) fail to recognize
critical audit areas, or 3) not be able to acquire the depth of knowledge
necessary for essential audit judgments. Thus, the argument is frequently
raised that price competition leads to a decrease in overall audit quality.
* Because the initial year of an audit will often require significantly more time
than examinations of subsequent years, price competition can lead a firm
to actually lose money in the first year of an engagement. Therefore, the
CPA firm must work to keep a client for several years to offset this initial
loss and produce a reasonable profit. The necessity of retaining an
engagement for a number of years may force the firm to be subservient to
management's demands to avoid being fired. This argument has lost much
of its impact over the last few years as client companies have established
audit committees comprised of outside members of the board of directors
to ensure the independence of the auditing firm.
* Many auditors also feel that price competition is generally detrimental to the
public accounting profession. The main thrust of this argument is that price
competition encourages companies to select their independent auditors
based primarily on cost rather than on the quality of audit work. This type
of selection process would favor firms offering cheap rates over auditing
firms offering quality services.
After the students have been allowed to discuss the problems associated with
price competition, the instructor may want to ask whether these problems
outweigh the advantages of having the auditing profession participate in the free
market system. Since most business students in the United States appear to
advocate free markets within the country, some interesting discussion can be
stimulated as to whether the auditing profession should be exempt from price
competition.
(8)
According to the audit risk model, planned detection risk (PDR) equals
acceptable audit risk (AAR) divided by the product of inherent risk (IR) and
control risk (CR). Holding inherent risk and acceptable audit risk constant, there
is an inverse relationship between control risk and planned detection risk. Thus,
an increase (decrease) in control risk leads to a decrease (increase) in planned
detection risk. Also, as planned detection risk decreases (increases), the amount
of substantive tests and other audit procedures increases (decreases). That is, if
the auditor determines the level of detection risk to be low, he or she wants the
chance of not detecting an error too small. In order to have a small chance of not
detecting an error, the auditor must do more testing. For example, given
AAR=10% and IR=80%, and assuming an 80% CR (high), then using the audit
risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but
assuming a 20% CR (low), then planned detection risk is a relatively high 62.5%
33
[.10/(.80x.20)].
(9)
According to SAS 99 the assessment of the risk of fraud begins with a meeting of
the entire team for such purpose. This brainstorming session needs to
encourage the involvement of all team members and cannot be just a staff
training session. The objective is to solicit the ideas from all team members and
to sensitize the entire team to the particular problem areas that this client
presents. The process begins with such a session, but does not end there.
During the audit the entire team needs to consider how the information being
developed relates to the areas already identified, noting new areas that need
attention, or adjusting expectations on the areas already identified. The areas
identified by fraud risk are primarily in the areas of inherent risk and control risk.
Increased fraud risk represents an increase in inherent risk (the risk that errors
exist) or will also increase the control risk (the risk that the client’s internal control
system will not detect the error or irregularity).
(10)
(1)
34
a) Ratio analysis from 2007 to 2008.
35
Ratio Industry Ave. Lakeside 2008 Significance
industry average.
Conclusion: Lakeside is well below the liquidity level of the industry, and the
company is in a significantly worse solvency level than the industry. Auditors
should be aware of methods to enhance the liquidity and solvency levels, such
as unrecorded liabilities. Lakeside profitability is about the same as the industry
average, except for return on equity, in which it is more than double that of the
industry (primarily due to the high level of leverage).
36
Procedure Results Significance
actual repairs may have been
made by Lakeside. In that
situation, the auditor needs to
verify that all capitalized costs
have been segregated and
properly accounted for within the
company records.
Scan the trial balance The "Gain on Disposition of Fixed Often a company will fail to
Asset" balance of $14,000 remove the appropriate cost and
warrants investigation. related accumulated depreciation
when a plant asset is sold. The
auditor should also ascertain that
the current year depreciation
expense has been properly
recognized. Finally, the sale of
an asset can lead to the
acquisition of a new asset as a
replacement. The independent
auditor should follow up on this
possibility to assure that any
replacement is appropriately
capitalized.
Scan the trial balance The Allowance for Doubtful The auditor should determine if
Accounts balance shows a debit the client has written off an
balance on September 30, 2009, especially large group of
compared to a credit balance one accounts. Perhaps bad debt
year earlier. experience is changing and a
larger allowance is required.
Scan the trial balance The company's two bank credit The auditor should verify that no
lines now have a total balance loan covenants have been
that exceeds the $750,000 broken. In addition, because of
maximum that was indicated in disclosure requirements as well
an earlier case. as the effects on the interest
expense account, the auditors
will need to review any new
borrowing agreement.
Scan the trial balance The long-term notes payable The auditor should determine the
have increased by $50,000. The application of those funds as well
auditor would certainly be as the loan agreement signed by
interested in the application of the company.
those funds as well as the loan
agreement signed by the
company.
Scan the trial balance Sales returns have increased The auditors need to ascertain
significantly for both the company the reasons for such an increase.
stores and the distributorship. Any change in the trend for sales
returns would lead the auditors to
reevaluate year-end accruals.
Scan the trial balance The equipment account shows If the company has acquired
an increase from the previous additional equipment during the
year. year, the auditor needs to verify
that capitalization and
depreciation were given proper
treatment.
37
Procedure Results Significance
Scan the trial balance The estimated bonus expense That increase is probably due to
has increased. the profit-sharing plan having
been in effect for all nine months
of 2009, but the increase should
be investigated.
38
CASE 4
(1)
39
the actual priority placed on internal control by the company. Documentation
of this should also be available for inspection. Rogers seems to understand
that better systems are needed but has invested neither the time nor the
money to develop such policies and procedures. This lack of support may
indicate that the management is not serious about establishing adequate
control within the company. Because of the company's growth, improvements
in the future may be forthcoming, but at the present time the management
appears (from what has been said) to have let the company outgrow its
control policies and procedures.
• Organizational structure. If Lakeside has a chart presenting the various
officials and their jobs, the auditors can assess whether control policies would
be easy to circumvent. Although Exhibit 3-2 shows the company divided into
clearly distinct areas, the Assistant to the President does seem to be in a
position to operate without proper control supervision. In addition, the
President seems to hold a significant amount of power in this company, with
very little control having been established.
• Assignment of authority and responsibility. This factor includes how authority
and responsibility for operating activities are assigned and how reporting
relationships and authorization hierarchies are established. Since Lakeside is
not a huge organization, Rogers tends to intervene in many of the operating
activities. However, as Lakeside continues to grow, this may become a major
concern to the auditors.
• Human resource policies and practices. These policies and practices relate
to hiring, orientation, training, evaluating, counseling, promoting,
compensating, and remedial actions. The auditors should inquire and
observe Lakeside's policies, including any standards for hiring the most
qualified individuals, training, and performance appraisals.
Risk assessment is the second component of internal control. The auditors will
determine and evaluate how Lakeside identifies, analyzes, and manages risks
relevant to the preparation of the financial statements. The auditors will want to
pay particular attention to several changes occurring at Lakeside and how the
management deals with these changes. These changes include the expansion
of the company's stores, the concentration on the Cypress product line, and the
relatively new bonus system.
Next, the auditors will look at the actual control activities in place to see that
specific control objectives are being met. Within this testing, the auditors should
look at the following as goals of the company's internal control:
40
proper authorization of transactions exist. The auditors can examine the
documentation produced for a variety of transactions to ensure that each was
authorized by the appropriate individual within the company. Further, the
auditors will verify that Lakeside properly designs and uses adequate
documents. By walking through the various systems, the auditors can
determine if adequate documentation is required at each point and if those
documents are preprinted and prenumbered to ensure that the proper
information is gathered and retained.
• Physical controls. By physical observation of the warehouse, the stores, and
other assets, the auditor can determine if Lakeside has adequate safeguards
over its assets.
• Segregation of duties. By looking at the organization of a company, the
auditors can determine if the necessary separation of responsibilities is in
place to facilitate adequate control. For example, since Lakeside has a chart
showing the various officials and their jobs, the auditors can assess whether a
true system of checks and balances has been established. Although Exhibit
4-1 shows the company divided into clearly distinct areas, information in
Exhibits 4-3 and 4-4 indicates, for example, that the Assistant to the President
has a great many responsibilities, some of which raise the possibility of
control problems.
Next, the auditors will have to examine any information that helps to
ascertain the efficiency of the company's information and communication system.
In the case presented, little data is provided to evaluate the information system
except that Rogers feels the systems are outdated for a company of this size.
Therefore, the auditors should assess the design of the system and the people
who operate the accounting system. For example, the auditors might want to
select a number of transactions and trace them from the point of origination
through the accounting system to see that the recording process is performed
properly. This testing is designed to determine if the system is capable of
performing the following tasks in an effective manner:
41
the home office.
(2)
An evaluation of the overall control environment is not possible from Exhibits 4-3
and 4-4. However, the auditors can see that responsibilities have been
developed and divided within the company. Each individual or department
seems to have a well-defined job within the two systems. Thus, some evidence
exists to indicate that management is aware of the importance of internal control.
Such systems simply cannot be created without adequate support by the
company's management.
In terms of risk assessment, Lakeside does not appear (from Cases 2 through 4)
to have a formal method of systematically assessing risks (Weakness). The
auditors should recommend a system of identifying risks, their significance, their
likelihood of occurrence, and how they might be managed. This is especially true
with Lakeside's growth of stores, concentration of suppliers (Cypress only), and
installation of a bonus system.
In addressing control activities, the auditors can see, as indicated in the answer
to Exercise (2), that the company seems to use adequate documents and
authorization procedures (Strength). In addition, although the Assistant to the
President has many different duties (Weakness), the company seems to have
made an attempt to segregate responsibilities in an appropriate manner.
Both of the information systems that are presented also seem well designed
especially for a small but growing company. However, the company still uses
some manual systems that can be slow and offer the opportunity for many
human mistakes to be made (Weakness). The answer to Exercise (2) goes into
more detail concerning control strengths and weaknesses in this area.
The monitoring activities seem to be somewhat lax. However, with Lakeside still
being relatively small, Rogers' oversight somewhat compensates for the lack of
monitoring. With the growth of Lakeside, this is becoming less true.
(3)
After a preliminary assessment of control risk, the auditors have three possible
actions:
42
risk is justified.
b) Because of weaknesses found within internal control, the control risk
may have to be assessed at the maximum level. This evaluation will
probably force the auditor to reduce detection risk by such means as
performing additional substantive testing, using more experienced staff
personnel, carrying out procedures closer to the balance sheet data, or
relying on more effective testing procedures.
c) Although potential strengths may be identified within internal control,
the auditors may still opt to assess control risk at the maximum level.
This decision would be made if additional substantive tests appear to
be easier and cheaper to make than performing the necessary tests of
specific control policies and procedures.
(4)
The auditor will normally begin verifying control policies and procedures by
making inquiries of the employees as to the performance of their duties. The
answers provided indicate to the auditor whether each individual understands the
duties that have been assigned as well as their purpose. A proper knowledge of
a job usually means that employees are more likely to comply with the system
and fulfill their responsibilities. In addition, the auditor is often able to observe
the work of these individuals during the audit fieldwork. From these
observations, an evaluation can also be made as to the quality of the work being
performed.
(5)
43
This new information provides an increased risk on the motivation/incentive for
fraud to occur, in terms of the fraud triangle. It does not mean that fraud has
occurred and does not affect the opportunity or rationalization necessary for
fraud to occur. The auditor faced with this information should document the
discussion, and make sure the audit team is aware of the conversation. It is not
the job of the staff auditor to initiate an investigation at this early point in the
audit.
(1)
a)
The following page presents a flowchart for the revenue recognition system.
Numerous acceptable variations of this flowchart may be created. This problem
is not intended to suggest a rigid format for the flowchart but rather to give the
student experience in constructing and reading one. When evaluating a
student's work, several questions should be asked:
One technique that might be used with this assignment is to divide the class into
teams of three or four students each. Then select a flowchart at random from
each team and ask the team members to critique it. This process, which can be
done inside or outside of class, will compel the students to view the flowchart as
an instrument intended to communicate the design of a system.
44
Exercise 1a
Client: Lakeside Company PF-12
System: Revenue and Cash Receipts Cycle - Distributorship Revenue Recognition Prepared JCD 9/10/09
Reviewed JVB 11/11/09
Reviewed EVK 12/10/09
Notes Sales Division Inventory Department Assistant to the President Controller's Office
From
Inven. No.
To To
Inven. Cust. Bill of Lading 3
With To To To
Shipmt Contr. Cust. Sales Invoice 4
Cust. Cust
(Approved)
Bill of Lading 4 Name
4 To
3 Contr.
Sales Invoice 2
(Approved)
To
Cust. Cust
Note F To Name
Current
Asst.
Price List
Due
Date
45
(1)
b)
Checks arrive from customers along with the copy of the invoice slip. The
checks are received by the Treasurer's Office where each check is immediately
stamped "For Deposit Only." The checks are listed on a bank deposit slip and on
a four-part cash remittance list. This listing includes the customer, the amount
paid, and the invoice number.
The checks and the bank deposit slips are taken by the Treasurer's Office to the
bank. The second copy of the bank deposit slip is validated and returned to the
Treasurer's Office where it is placed in a permanent file by date along with the
fourth copy of the cash remittance list. The bank returns the first copy of the
validated bank deposit slip directly to the Assistant to the President where it is
placed in a temporary file by date.
The invoice slips and the first three copies of the cash remittance list are sent by
the Treasurer's Office to the Sales Division. The second copy of the sales
invoice and the fourth copy of the bill of lading had originally been filed by that
department when the goods were shipped. Each invoice slip is matched with the
corresponding sales invoice and bill of lading. The appropriate discount is
calculated and recorded on each copy of the cash remittance list. Each invoice
slip is then attached to the appropriate sales invoice and bill of lading and placed
in a permanent file by invoice number. The third copy of the cash remittance list
is placed in a permanent file by date.
The second copy of the cash remittance list is sent to the Controller's Office
where the cash receipts and the sales discounts are refooted. From this
information, a daily journal entry is made in the cash receipts journal.
Subsequently, the second copy of the cash remittance list is filed permanently by
date.
The sales division sends the first copy of the cash remittance list to the Assistant
to the President. He compares the bank deposit slip that he has received from
the bank against the total of the cash remittance list for that same date with a
spot check of individual items. The list of collections is then used to update the
Accounts Receivable Subsidiary Ledger before being placed in a temporary file
by date. Upon receipt of the monthly bank statement, the cash remittance lists
and the validated bank deposits are removed and used to prepare the monthly
bank reconciliation. The reconciliation, the bank statement, the validated deposit
slips, and the cash remittance lists are then placed in a permanent file by date.
46
(2)
The student is asked to complete Exhibit 4-5, a preliminary analysis of the control
procedures in the cash receipts system.
• Invoice Slips (one copy per payment) - prepared internally but returned
directly by outside party. It is the bottom portion of the number 4 copy
of the sales invoice.
• Validated Bank Deposit Slips (two copies per day) - prepared internally but
validated by outside bank and mailed directly to the Assistant to the
President.
• Bill of Lading (only fourth copy is a part of this system) - prepared internally,
two copies sent to customer.
1. Prenumbering of forms - Exhibits 4-3 and 4-4 indicate that the sales invoices
(including the sales invoice slip) and the bills of lading are prenumbered.
None of the other documents shown in this system would normally be pre-
numbered.
2. Authority for completing each document - Exhibit 4-4 indicates that all
documents within this system are clearly assigned to a specific department.
47
4. Procedures for completing each document and for reviewing each document -
all instructions on the worksheet appear to be reasonably complete, although
any set of written instructions could be put into more detail. One problem
does exist: none of the instructions give guidance when discrepancies are
found. For example, according to the flowchart, a major problem exists in the
sales division at point B. According to the explanation, no instructions exist
when the collection is less than the amount of the invoice. Rather than
rebilling the additional amount, the invoice information is placed in a
permanent file. Although this rebilling process may be handled through the
Assistant to the President or some other party, this procedure is not indicated
by the flowchart.
- spot checks made of cash remittance list totals to bank statement deposits
are made to counter potential "lapping" activities.
10. Other control weaknesses that might be noted by the students - invoice slips
and related documents are permanently filed by invoice number in the sales
division rather than by customer name without any apparent cross-
referencing. In case of a later dispute, locating the invoice might be difficult.
48
(3)
• Use a sales order form that is different from the sales invoice. The two
documents serve different purposes and are most useful if designed to
meet those specific needs.
(1)
The board of directors needs to be organized so that it can fulfill its purpose. The
primary improvement is to increase its independence and operation. The
President of the Corporation should need be the Chairman of the Board of
Directors and there should be sufficient independent board members to manage
create a truly independent audit committee. Under Sarbanes-Oxley the audit
committee is the primary interface with the registered CPA firm.
Other structural changes may involve management and their duties. Unlike the
previous non-public audits, violations of segregation of duties, or lack of audit
trail might trigger a significant deficiency or material weakness notification.
Therefore, while in the past expanded substantive testing was possible in the
event of internal control deficiencies, SAS 112 requires the communication of
49
all such problems in the context of the audit or the management report on the
internal control system.
(2)
The audit or internal control is still relevant in the determination of the audit risk
model and the determination of detection risk relative to the audit of the financial
statements, however Sarbanes-Oxley requires that public company management
report separately on the internal control system over which they are responsible.
Further, the registered CPA firm must audit that management report.
The result is that Abernathy and Chapman must evaluate the effectiveness, and
test the effectiveness of the internal control system regardless of its impact on
the financial statement audit. In most cases this would involve increased auditing
and therefore higher fees.
50
CASE 5
(1)
SAS 31, "Evidential Matter," states that: "The measure of the validity of
[evidential matter] for audit purposes lies in the judgment of the auditor...." (par. .
02) Thus, the quality of oral evidence is an evaluation made by the auditor that
would be influenced by a number of factors: the perception of management's
integrity, the rank of the individual providing the information, the ability to
corroborate the evidence by other sources, and the purpose for which evidence
is being gathered. However, in all cases, statements made by the employees of
a client are only circumstantial evidence. In a comparison with other forms of
evidence (such as observing physical existence and receiving confirmations
directly from third parties), it provides less assurance.
(2)
51
• Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the
collection is not recorded, another invoice will eventually be sent to these
customers who would then alert the company to the earlier payment. To
prevent the processing of this second bill, subsequent cash collections from
other customers are applied to the balances of the original customers. This
series of events can be repeated indefinitely. Money is stolen on a daily or
weekly basis to cover each previous theft.
(3)
A company's net income can always be inflated by creating fictitious credit sales.
For example, an invoice is prepared for a fake customer with the amount being
recorded as an increase in both accounts receivable and sales. In the Lakeside
audit, the client company wants to grow. Bank loans or new equity investments
may be needed for this purpose. Increased income would make this type of
financing easier (and, perhaps, cheaper) to negotiate. False sales might also be
created for a different reason: the regional sales representatives are paid a
commission based on sales. Thus, to inflate their own income, they might
attempt to falsify sales records.
Students may also suggest that fictitious sales will inflate the profits of the
individual stores and, thus, increase the bonuses paid to the manager and
assistant manager. However, this case indicates (as does the balance sheet in
Case 3) that all credit sales are made by the distributorship side of the business.
The stores do not sell on credit so that fictitious sales cannot be created through
the recording of extra accounts receivable.
(4)
In talking with client personnel, an auditor must be constantly alert for any
indication of potential problems. "Red flags" are often encountered in these
discussions that need to be investigated to ensure that material misstatements
do not exist. During Mitchell's conversation with Miller, a number of comments
are made that should concern the auditors:
52
individual could make an adjustment to a balance without Miller noticing.
The receivable of a friend or relative, for example, could be reduced.
• Aging of the receivables is performed only once a year. Although Miller
claims that he can monitor the age of individual accounts, the company
needs to be aware of changes that occur over time. For example, the
increase in the age of the receivables during the current period seems to
have gone unnoticed. Consequently, the company's assets are tied up for a
longer period of time and the chance of accounts becoming uncollectible
increases. The company needs to be in a position to take corrective action
as soon as this type of problem begins to occur.
• Miller controls the accounts receivable subsidiary ledger with virtually no
company oversight or control. For example, no reconciliation with the
general ledger is made except for the auditor's testing once a year. Errors
and evidence of irregularities could exist and not be discovered for months.
• Complaints about billings are handled by Miller rather than by someone
independent of the system. The handling of complaints is an important
method of control especially in an accounts receivable system, since
regular interaction with outside customers occurs. This control mechanism
is neutralized, however, if Miller is assigned to look into and resolve the
problems.
• No formal system exists for setting credit limits and granting credit. Rogers
appears to handle this aspect of the company based almost on intuition.
Thus, potentially excellent customers may have their credit limited while
risky customers are given excessive credit. A formalized system needs to
be developed with some oversight included.
• Credit is based solely on reports that are filed by the sales representatives.
These individuals have a direct interest in getting additional sales since
they are paid on commission. Thus, they have reason to want each report
to sound as if the customer is worthy of credit. Additional independent
information should be accumulated to help the company decide on the
granting of credit.
• The credit files are never updated. Therefore, the company learns that a
customer is no longer a good credit risk only by incurring a loss, the writing
off of a balance as a bad debt. Therefore, customers in financial difficulties
can run up large debts that will never be paid. The company needs to
establish a periodic review of credit information to ensure that each
customer is still worthy of credit. The age of the accounts receivable is up
significantly from the previous year without any good explanation. Miller
blames the change on Christmas, but the effects of that holiday would have
also been encountered in the preceding year. The possibility exists that bad
accounts or false accounts are now included within the receivable balance.
• Miller indicates that the company might have previously been holding
accounts rather than writing them off as bad on a timely basis. The auditor
must be concerned that this practice is still being followed. Companies will
often attempt to manipulate net income by varying the point at which
accounts are determined to be bad.
53
• No justification seems to exist for using .7% of net sales as the estimation
of bad accounts. The auditor cannot corroborate a number that appears to
have been selected at random. A new attempt must be made to derive an
estimation that is a reasonable representation of the company's
uncollectible accounts.
• The company waits until an account is 15 days old before a second invoice
is mailed. This delay is, perhaps, one of the reasons that the age of the
accounts has increased. Many customers may be waiting for the pressure
of the second bill before making payment.
• Miller writes off accounts as uncollectible with no apparent company
control. Since bad accounts may indicate errors or irregularities, they
should always be reviewed and approved by some independent party
within the organization.
• Miller produces and mails the final invoice for overdue accounts. Since
Miller has a great many responsibilities in this system, this last billing
should be made by some other individual. Therefore, if the account has
been paid (and stolen or incorrectly recorded), the information comes back
to this independent person.
• Prices and extensions of invoices are sometimes checked after the invoice
has been mailed to the customers. This system is obviously inefficient.
Payments may be made incorrectly, and customers can become
aggravated by later adjustments being made.
(5)
(6)
54
quantity and size of transactions occurring over time, the past history of the
company in this area, the likelihood of theft, the necessity of performing
complicated calculations in order to generate reported figures, problems inherent
to a particular industry, the need for making estimations, the results of analytical
procedures, and the possibility of obsolescence. For example, in the Lakeside
audit, inventory would be an account that would probably have a high inherent
risk. The company has numerous transactions in both buying and selling
inventory. Computations of discounts and freight charges could be difficult, as
would be the application of a cost flow assumption. The possibility of theft,
breakage, returns, and obsolescence of inventory would all be high and require
periodic estimations.
The auditor's assessments of both inherent risk and control risk have a significant
impact on detection risk and, therefore, substantive testing procedures. If the
inherent risk and control risk are both determined to be low, detection risk need
not be kept low. Thus, less substantive testing (both in quantity and quality) is
needed. Conversely, if the inherent risk and the control risk are judged to be
high, the auditor must reduce detection risk. As discussed above, this risk can
be brought down to an acceptable level by such means as performing additional
substantive testing, using more experienced staff personnel, carrying out
procedures closer to the balance sheet date, or relying on more effective testing
procedures.
(7)
(8)
55
b) The account is quite large in relation to other accounts receivable;
c) The account is far overdue, indicating a possible bad debt to be written off
or that payment has not been properly recorded;
d) The activity within the account has been unusual. For example, later
invoices were paid while earlier charges were ignored.
(9)
• Sales Journal - indicates the original journal entry recorded for each sales
transaction. An auditor matches the debits in the general ledger account to
these journal entries to ascertain that no posting errors have been made.
• Bill of Lading - records the quantity and description of the items being
shipped. The auditor compares it with the sales invoice to make certain that
the items ordered and billed are in agreement with the items that were
shipped.
• Inventory Price List - used to price sales invoices. An auditor can use this
listing to verify correct pricing of the sales invoices.
56
and does indicate an appropriate interface between the two systems.
Although the following documents are not part of the audit trail leading to the
recording of the Accounts Receivable debits, they are certainly relevant to any
testing made in connection with the fair presentation of those debits:
Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips - some
or all of these documents can be used by the auditor to verify the actual
amount of cash received. The question of collectibility is best answered by
actual collection of the receivable. Thus, the auditor will compare the debit
entries in the receivable account to the subsequent cash collections.
This question also asks about the reliability of the evidence gathered from this
audit trail. Lakeside's audit trail is composed entirely of internally generated
documents. For example, even the original customer order is taken by telephone
and recorded by Lakeside employees. Thus, the reliability of the documents that
comprise this trail such as bills of lading or sales invoices would be closely tied to
the auditor's evaluation of internal control. If controls are perceived as strong,
the reliability of these documents is much higher than if controls are weak.
Because the audit trail is composed solely of Lakeside documents, the student
should be aware that testing this trail provides the auditor with only a portion of
the necessary evidence. Collection of the accounts receivable, for example, and
auditor confirmations would also provide evidence as to the fair presentation of
the accounts receivable.
(10)
Miller is uncertain how the 0.7% figure was determined. He says that the
previous auditors determined this figure several years ago, and that the company
has always used this figure. Obviously, this is not a reasonable method for
estimating bad debts. The figure should be evaluated by Lakeside's management
at least annually for its reasonableness. This evaluation should include a review
of the history of uncollectible accounts, the current credit policy, and the current
aging of accounts receivable.
(11)
(12)
57
Consistent with our answer in #11 above, Miller has not designed an effective
system. It is not unusual for a company to grow and what worked before can no
longer be relied on to handle the increased volume. Miller seems to exhibit a lax
attitude in several of his answers and therefore, since he is responsible for the
system, we must conclude that he has not made good decisions.
Note: Although no specific question relates to the following matter, students may
detect that a contradiction exists between a statement made by Miller here in
Case 5 and the system memorandum presented in Exhibit 4-3. Miller indicates
that he verifies the prices and extensions reported on sales invoices. Exhibit 4-3
states that this control procedure is performed by the Controller's Office.
Although this discrepancy could mean that Miller's assertion is incorrect, it
probably signifies that the system has been altered subsequent to the
development of the memorandum. Discussion of this contradiction is a good
lesson in the importance of constantly updating the firm's knowledge of the
client's systems and internal control.
(1)
QUESTION (1)
QUESTION (2)
Comments - The criteria for writing off accounts are nebulous and seemingly
based solely on the judgment of Miller.
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over Miller's judgment.
Suggestion - Establish a formal system for writing off bad accounts. This system
need be no more than a list of steps to be taken prior to the decision to remove
an account. Company needs to ensure a review of these accounts.
QUESTION(3)
Significance - The removal of bad accounts can be used to cover cash thefts.
Also, write-offs may be approved without sufficient attempts being made at
collecting the receivables.
Suggestion - Once a system has been established for the write-off procedure
(see Question 2), an independent employee should be required to review every
account prior to removal to make certain that all proper steps have been
followed.
QUESTION (4)
Comments - Follow-up of bad debts is not addressed in the case; Mitchell does
not ask this specific question.
QUESTION (5)
Significance - No proof exists that the bad debt expense and the allowance for
doubtful accounts is fairly presented.
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QUESTION (6)
Comments - The first three invoices are mailed by the sales division; any further
billing is made by Miller, who is in charge of the subsidiary ledger.
Significance - By having Miller send the last invoices, the opportunity for
manipulation is increased. In a small company such as Lakeside, this situation is
not unusual, but it should be accompanied by additional control and reconciliation
features.
QUESTION (7)
Significance - Again, all of the responsibilities are in the hands of one person with
no independent control being applied. This lack of control reduces the possibility
that errors will be discovered. Basically, an opportunity to establish control over
Miller's work is being missed.
QUESTION (8)
Significance - Any shift in credit policy requires auditor attention as to the effect
on the allowance account and bad debt expense. Abernethy and Chapman may
want to review the new customer accounts opened during the current year for
any indication of a change in credit policy. This issue may be especially
significant in the Lakeside audit since credit reports are filed by the sales
representatives who are paid on commission, thus benefiting from an increase in
sales.
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decisions. In addition, outside verification of credit ratings on a periodic basis
would help reduce the risk of high bad debt losses.
QUESTION (9)
Significance - To the auditor, the possibility of a sale being made without credit
approval casts further doubts on the reliability of the system of controls. As a
part of the tests of controls, the auditor will want to review a sample of sales
invoices for proper credit approval.
Suggestions - At the point in the accounting system at which the extensions and
prices are verified, the presence of credit approval should also be checked.
QUESTION (10)
Comments - Credit files contain only the sales representative's credit reports and
do not appear to be reviewed periodically.
Significance - As indicated above, the credit granting policy is informal and based
almost solely on Rogers' judgment. Thus, the efficiency of the system is
unknown, and review of the system by the auditor is quite difficult.
QUESTION (11)
Significance - Verifying extensions and prices after the invoice has been sent to
the customer is not a logical approach. Also, having Miller perform this task adds
nothing to the efficiency of the organization.
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Suggestion - All verifications should be made prior to mailing the invoice, ideally
by a different employee.
QUESTION (12)
The answers to Question (11), above, appear to pertain equally as well to this
question.
QUESTION (13)
Suggestions - None
QUESTION (14)
Comments - Using prenumbered sales invoices and bills of lading along with the
periodic verification of all numbers is essential in assuring that all sales are
recorded. In an earlier case, the use of prenumbered forms is mentioned. Miller
suggests that the presence of all forms is tested periodically, but the auditor
should specifically ask about that procedure.
Significance - If the possibility exists that the company can make sales without
recording them, the auditor's ability to gain assurance as to completeness
assertion may be severely hampered.
Suggestions - Since the documents are already prenumbered, the auditor needs
to make certain that Lakeside has a policy for periodically verifying the presence
of all forms.
(2)
STEP (1-a)
Anticipated Results - The total listed on the sales invoice should agree with the
total on the sales invoice slip. In addition, evidence should be present to indicate
that a Lakeside employee has already made this same comparison.
Potential Problem - If the invoices do not agree, the possibility is raised that
fictitious or misstated sales are being recorded. Lack of tangible evidence (e.g.,
initials) that the matching procedure has been carried out would indicate that the
62
employees are not complying with the requirements of the system.
STEP (1-b)
Anticipated Results - The quantity and description of the items sold should be the
same as the items shipped. Again, Lakeside employees are supposed to have
previously made this comparison and left their initials or other proof of the
execution of this test.
Potential Problem - Differences warn the auditor that sales have been both billed
and recorded incorrectly, or incorrect amounts or types of inventory have been
shipped. Once again, a lack of compliance by Lakeside's employees may be
shown if this comparison has not been made.
STEP (1-c)
Potential Problem - The cash may have been stolen, or someone in the company
may be engaged in lapping.
STEP (1-d)
STEP (1-e)
Anticipated Results - All prices on the invoices should agree with the prices being
shown on the approved price list.
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Potential Problems - Wrong amounts may be paid by customers. Improper
pricing, either intentionally or unintentionally, also leads to incorrect sales and
receivables figures on the financial statements. If the invoice price is too high,
sales and income are overstated; if too low, the figures will be understated, and
company employees may be receiving kickbacks from customers.
STEP (1-f)
STEP (1-g)
Anticipated Results - The amount received according to the invoice slip should
agree with the listing of individual items being deposited. In addition, the date of
deposit should be the same as the date on which the payment is received.
Potential Problems - A discrepancy could indicate the theft of the cash receipts.
This test also may alert the auditor to the possibility of lapping.
STEP (1-h)
Potential Problems - Since the subsidiary ledger is not well controlled in the
Lakeside organization, this procedure may be used to determine the possibility of
errors within the ledger. This test also may indicate lapping as well as other
manipulations of the accounts so as to conceal cash shortages.
STEP (1-i)
Potential Problems - Because the credit system is not well documented, the
auditor will be searching for evidence that sales can be made without credit
approval. Such evidence would have an effect on the auditor's judgment as to
the amount of evidence needed in examining the allowance account and bad
debt expense.
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STEP (2-a):
Potential Problems - This test has major significance in that it can alert the
auditor to any falsification of sales for the year. Fictitious sales could easily be
created by Lakeside since they prepare all sales invoices and other documents
internally.
STEP (2-b):
Anticipated Results - Each credit should agree with the cash remittance list as to
amount and possibly date of payment depending upon the method of posting.
Potential Problems - This tracing could denote errors in postings within the
system. Errors could indicate lapping by company employees.
STEP (2-c)
Anticipated Results - Each credit to a specific account should agree with the
listing of individual items on the bank deposit slips.
STEP (3)
Anticipated Results - For each of the customers, complete and updated credit
reports should be on file.
STEP (4)
Anticipated Results - Each list should be arithmetically correct. Its total ought to
agree in amount and date with the balance entered in the cash receipts journal.
Potential Problems - Cash shortages and cash thefts are often covered by
incorrectly footing a listing of cash transactions.
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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION
(1)
This question is similar to the SOX question in Case 4. The emphasis is on the
difference between public and privately held companies. The difference involves
the testing of the controls. In the public company setting controls are always
tested because of the separate disclosure by management of their evaluation
and testing of their system. In both public and privately held companies the
evaluation and possible testing of internal controls by the independent auditors is
related to the financial statement audit. The amount of substantive testing and
the determination of the detection risk is related to the internal control risk.
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CASE 6
(1)
• the case implies that the company uses preprinted forms so that adequate
information is captured whenever a document is prepared;
• all invoices are matched with the appropriate purchase requisition and
receiving report before payment is approved;
(2)
Canceled checks are the last document in this system, while receiving reports
are one of the first. Whenever auditors select a final document such as a
canceled check and search for its documentation, they are seeking to
substantiate the validity of the balance being reported. All forms and documents
must be present to prove that the amount and the company's reporting were both
correct. Such testing also seeks to discover whether false transactions have
been entered into the system. For example, if a canceled check is found without
a corresponding receiving report or purchase requisition, the possibility exists
that money has been stolen from the company; a payment was made for
merchandise that was not ordered nor received.
Taking a beginning document such as a receiving report and tracing the impact
of the transaction through an entire system is intended to provide evidence of
completeness and that the system and its controls are working as designed.
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Obviously, such testing will also provide evidence as to the validity of the account
balance, but this particular procedure is more often associated with the
completeness assertion and internal control evaluation.
(3)
How might Lakeside pay for goods that were received? The company could, as
an example, receive an invoice and not properly match it with the corresponding
receiving report. The receiving report might state that 10 items were actually
acquired while the invoice was for 20 or 100. The individual doing the review
may not notice the discrepancy and erroneously approve the invoice. As another
possibility, this individual might authorize an incorrect invoice in order to receive
a kickback from the vendor.
How might Lakeside fail to pay for goods that were not received? If either the
receiving report or the invoice is lost, the documents will not match and payment
cannot be made. Thus, the company may wait indefinitely for the other (lost)
form before approving the cash disbursement.
(4)
(5)
A CPA firm must establish policies and procedures for the supervision of work at
all organizational levels to provide reasonable assurance that the examination
conforms to generally accepted auditing standards. Procedures for supervision
are necessary to ensure that appropriate judgments and conclusions have been
drawn from the work performed. Not every member of an audit team will have
the expertise necessary to evaluate the handling of each accounting and auditing
problem that arises. Furthermore, some of the audit staff may lack an in-depth
knowledge of the client or the client's industry, thus increasing the possibility of
incorrect judgments. Supervision by auditors having the necessary experience
and expertise provides reasonable assurance that sufficient evidence and proper
conclusions were obtained.
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Auditing literature places emphasis on the existence of appropriate supervisory
policies and anticipates that practices will be used by a firm in each audit
engagement to verify proper supervision. One such procedure is to have staff
members leave their initials to indicate the completion of a test or later review.
Thus, the working paper shown in Exhibit 6-1 was originally produced by Art
Heyman (AH) and subsequently reviewed by Carole Mitchell (CM), and Wallace
Andrews (WA). From the location of the initials, this auditing firm must require
acknowledgment at every point of audit judgment to indicate that the supervisors
concur with the actions taken. This policy enables the firm to monitor the degree
of supervision in each area of the audit as well as to ensure that no critical
problem will escape the attention of supervising auditors.
(6)
(7)
(8)
Audit procedures are the steps that are required to test a particular control,
transaction, or account. Some firms write procedures specifically designed for a
particular audit client. Also, some firms have standardized audit procedures for
use on all audits. For quality control standards, standardized procedures are
69
preferable to ensure that all audits are performed in a like fashion. However,
these standardized procedures should be supplemented with procedures
designed to meet the particular circumstances of each client.
(1)
Exhibit 6-1 may well be a student's first view of audit documentation. Therefore,
discussion of its clarity and completeness should force the student into a close
examination of the structure and function of the document. Students should be
encouraged to discuss the strengths of this particular working paper as well as its
weaknesses.
The audit procedures seem generally clear, although they do contain some
problems. For example, the fifth procedure states that the auditor "examined
canceled checks for amounts, dates, signatures, endorsements, and payee."
Obviously, the auditor is not just physically examining this information but is
confirming the data against some other document (the invoice). This
reconciliation is not clearly stated. Also, in the seventh procedure, no indication
is given as to the purpose of verifying the account code.
Exception (A) is poorly written. The staff auditor does not indicate whether the
$200 and the $360 amounts are over or under the current list price. Additionally,
the explanation for the discrepancies is vague. Stating that "the difference
represents monthly purchases from Cypress at different prices than shown in
current price list" indicates nothing about the reason for the change. The major
problem, though, with this explanation (and the actual testing procedure) is that
Thomas' word is accepted as an adequate explanation for the discrepancy. The
auditor provides no information that any further testing has been carried out to
verify these amounts. The assumption has apparently been made through the
comment "Pass Further Work" that the differences are immaterial and, thus, do
not require additional testing. Since all of the supervisors have added their
initials, concurrence appears to exist with this evaluation. Students may want to
discuss whether these two discrepancies warrant further examination and, if so,
what testing could be performed.
Exception (B) is also vague and poorly written. Once again, Thomas' explanation
is apparently accepted without further question or testing. The comment does
not indicate the amount of the differences that are involved in this replacement.
Therefore, judging the materiality of the items will be quite difficult for the audit
supervisors.
Exception (C) seems relatively clear. An auditor would prefer to see this policy in
an official Lakeside manual rather than accepting oral evidence, but in a small
70
company such as Lakeside, that may not be possible. The auditor should adjust
the flowchart and memorandum for this system to include this discovery.
On the whole, other than comments A and B, this working paper appears to be
clear and comprehensive. By reviewing the steps of the audit program listed in
this case, students can see that Heyman has performed the audit procedures
designed by Mitchell.
(2)
In reviewing this audit document with students, the instructor should be aware
that this question was developed with several educational objectives in mind:
(3)
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Lakeside Company W.P. No. N-3
Tests of Receiving Reports and Cash Disbursements 1
12/31/09 Accountant: AH
Date: 12/3/09
Audit Objective:
To verify that items received were properly ordered, received, and paid.
Scope:
• Population: All receiving reports prepared during the period under audit.
• Sample: Judgmentally selected 12 receiving reports from inventory department file. Pulled
reports sequentially, randomly starting with #3918.
Audit Procedures:
Review receiving reports. All complete and signed by inspectors, except A.
∅ Compared receiving report with purchase invoice for quantity and description. All agreed except
B.
Compared receiving report to purchase requisition for quantity and description. All agreed except
B and C. All requisitions approved by Rogers or Miller.
Invoices reviewed for compliance to see if they were checked, extended, and footed by Lakeside
employees. All were except D.
Compared invoice prices with Cypress Master Price List. All agreed except E.
t Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount. All
agreed except E.
Audit Conclusion:
Further testing necessary because of exceptions noted.
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Lakeside Company W.P. No. N-3
Tests of Receiving Reports and Cash Disbursement (cont.) 2
12/31/09 Accountant: AH
Date: 12/3/09
Comments
A Receiving report not in file. Client should be asked to find it or provide a reason for its absence.
Unless it is accounted for, the scope of testing may need to be expanded. AH
B On two invoices Cypress billed Lakeside for items different from those received. In both cases the bill
was for the items ordered, not those received. R.R. #3923 shows an item that is more expensive
than the one billed, while R.R. #3927 has an item that is less expensive than the one billed. The
purchase requisition for R.R. #2923 indicates Lakeside's acceptance of a replacement but no
indication in connection with R.R. #3927. Lakeside has paid for goods ordered, not goods received.
This reflects a serious problem with both the Lakeside and Cypress systems. AH
C Some receiving reports indicate receiving a different amount of goods than ordered. Requisitions
indicate that goods have been backordered in both cases. Lakeside, however, paid only for goods received.
System is functioning properly. AH
D No indication on this invoice that pricing, footing, or extensions were verified. Other invoices show
initials and tick marks. Failure to comply with the system in this one case. AH
E In a number of cases, invoice prices were less than the Master Price List. There seems to be a
discount on special items, but more evidence is needed. AH
F One invoice was reduced by a 4% discount, instead of 3%. Further inquiry required to determine
reason. AH
G In virtually all cases, checks were issued 2 or 3 days after the 20-day deadline for taking discounts, but
Lakeside took the discount in every case. Further inquiry is required to determine if Lakeside still
has a liability for these amounts. AH
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CASE 7
(1)
(2)
This case describes the payroll system used by the Lakeside Company. Tests of
controls are designed by the auditor to verify that specific control features
identified as possible strengths are operating effectively. A sample of such tests
would include the following:
i. Verify that each payroll record has been properly authorized by Mark
Hayes;
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j. Compare the payroll transfer made from the general fund each period to
the total payment computed on the payroll record;
k. Review canceled checks for proper signature, amount, payee, date, and
endorsement;
l. Review payments made for withholdings and payroll taxes. Compare these
amounts to payroll records kept for each of these items.
(3)
Rights and Obligations - For payroll expense, the auditor would want to ascertain
that work did occur during the period for which the company does have a legal
obligation to pay. The auditor would review the time tickets to make sure that
they seem proper and then recompute the amounts to be paid based on the
hours worked. These calculations provide evidence that the payments were,
indeed, the actual obligations of the client company.
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beginning and ending of the fiscal year. Determination needs to be made that
the figure being reported is for 2006 only.
Presentation and Disclosure - The auditor wants to make certain that the
financial statements fairly present the payroll expense figure. As shown in
Exhibit 3-1, a balance for "Salaries, Commissions, Bonuses" is reported for both
the stores and the distributorship. The auditor needs to determine that the
separation into these two classifications is properly performed. In addition, the
specific accounts included within this single category should be consistent from
year to year so that comparability is enhanced. Since the company does not
manufacture its inventory, no portion of the payroll expense should be assigned
to Cost of Goods Sold.
(4)
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of operations.
This question also asks about the competence (significance and reliability) of
these procedures. Each test is potentially quite important and produces reliable
evidence but only if used in the appropriate circumstances. For example,
confirmation is one of the most important steps in auditing cash bank balances
but is rarely used in connection with an account such as land. Physical
examination is essential in auditing marketable securities where ownership and
value can often be ascertained visually. This same procedure is much less of a
factor in examining equipment. An audit procedure must match an account and
the type of evidence needed.
(5)
• Allows for easier application of control procedures such as limit tests, item
counts, and validity checks;
• Allows for additional control over unclaimed checks, uncashed checks, etc.;
77
• Facilitates the audit function in that the payroll balances are easier to verify;
(6)
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• Review payroll tax forms for agreement with computed balances and
with payroll register.
• Review last payroll for the year to verify that recording was made in
proper period.
• Recalculate accrual and verify against the first payroll of the subsequent
period.
(1)
• The working paper is not properly dated so that a reviewing auditor cannot
be certain that this testing applies to 2009.
• The columns are not labeled. No method exists for identifying the
information that has been gathered.
• In the first three columns, abbreviations such as "SM," "M-2," and "Salar."
are used without explanation, which makes possible the erroneous usage of
the information.
• In the column that starts with $388, the seventh item and two items in the
next column do not have tickmarks, which may indicate that they have not
been tested. No indication is given as to the significance of these three
omissions.
• According to the working paper, none of the items in the column that begins
with $39 has undergone any testing. That possibility seems unlikely, since
an exception has been found at point A.
• Comment A is vague and does not indicate any reason for the exception
nor does it discuss the significance of the problem. In addition, the note
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makes no mention of potential testing that may be required because of the
exception.
• Two canceled checks could not be found at point B, but no reason is given
nor is any suggestion included for further testing.
• One tickmark (a caret) was used for two different tests. The reviewer has
no method of distinguishing the actual procedure performed.
• Several of the auditing procedures listed at the bottom (on the left) use
vague terms such as "company records," "government records," and
"calculations" without any specific identification. Thus, determining the
procedures actually performed and the specific documents analyzed would
be virtually impossible.
• The working paper does not contain objectives, scope, or conclusion (see
Exhibit 6-1). Therefore, it does not clearly spell out what was done or what
was found. No indication is presented as to the method of selecting the
employee names that have been used.
(2)
b It appears that the 2008 bonus expense account is overstated (actual balance
= $6,000 v. estimated balance = $3,940); however, the amount of
overstatement ($1,060) does not seem material. The 2009 expense appears
to be overstated by $8,184 (= $19,500 recorded - $11,316 estimated). This
overstatement represents approximately 6% to 7% of net income and, thus, is
fairly significant; however, since it overstates an expense, it understates net
income. The auditor could either accept the balance or suggest that the client
make an adjustment.
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Exhibit 7
Lakeside Company
Notes: Lakeside makes an "imputed rent" charge to Store No. 6 for the purpose of determining this bonus. Sales (A/C
500); Sales Returns (Prepared by Client); Cost of Sales (A/C 550); Direct Salary Expense (A/C 580); Rent (Prepared by
Client).
During the audit of the internal control system (Sect 404), the CPAs can conclude
that the management report on their evaluation and audit of the system is fairly
stated and that the system works as it was designed and the design is effective.
That is the best case situation. Problems create other reporting options based
on whether the management report identifies the problem, or the CPAs have
found a problem that is unreported by the management. It is possible to
conclude that the management report is fair and the system is ineffective and the
significant deficiencies have been identified both in the management report and
the CPA internal control audit.
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adequate internal control over financial reporting and give its assessment of
whether or not internal control over financial reporting is effective. According to
the rules, management cannot state that internal control over financial reporting
is effective if even one material weakness exists at year-end.
• Auditor’s report. The independent auditor will evaluate and report on the
fairness of management’s assessment. The auditor also will perform an
independent audit of internal control over financial reporting and will issue an
opinion on whether internal control is operating effectively as of the assessment
date (i.e., the company’s fiscal year-end). If one or more material weaknesses
exist at the company’s fiscal year-end, the auditor cannot conclude that internal
control over financial reporting is effective.
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CASE 8
(1)
• The cost flow assumption (FIFO, in this case) may have been improperly
applied in the perpetual records.
• Goods in transit could have been incorrectly handled in either the perpetual
records or the physical inventory.
• The specific cost assigned to each inventory item might have been incorrect
in certain cases.
• The final inventory listing (Exhibit 8-4) may have been extended or footed
erroneously.
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taking of the physical count, the possibility of errors in the quantity of inventory
should be at a minimum. Additional testing, such as verifying the costing, the
extensions, and the footings will further reduce the risk of a material error in the
figure to be reported.
(2)
(3)
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possible incentive is to push earnings from a very high performance year into the
next to smooth out a growth curve and avoid having to achieve that record again
in the following year. In a different vein, if the company must undergo union
contract negotiations in the near future, reporting less net income might prove to
be advantageous. However, little evidence exists in this case to indicate that
Lakeside's management would be tempted to reduce reported earnings except
possibly for the accompanying reduction in current taxes.
(4)
In the engagement letter prepared by Abernethy and Chapman (see Exhibit 3-1),
the firm stated that it expected "to obtain reasonable but not absolute assurance
that major misstatements do not exist." When a material misstatement goes
undetected and is reported in the client's financial statements, the question to be
raised concerns the difference between reasonable and absolute assurance. In
assessing responsibility in such cases, the public accounting firm is judged
against the work of the average prudent auditor. The firm must provide proof that
the examination was performed at least as well as would have been done by the
average prudent auditor. If a misstatement is missed that would have been
detected by the average prudent auditor, the firm is normally considered to be
guilty of negligence in the performance of the audit examination. In that case,
any losses incurred by the client company resulting from this mistake can be
recaptured from the firm. However, because Lakeside is privately owned, the
CPA firm will probably be liable to third parties for losses only if gross negligence
can be proven. Unfortunately, the distinction between negligence and gross
negligence is not clearly delineated by the courts.
(5)
A decision to observe less than 100% of the ending inventory always exposes
the auditor to some degree of risk. This risk is based on the possibility that a
material misstatement exists in the inventory not being observed. Three factors
would reduce that risk level in the audit of the Lakeside Company. First,
according to the September 30, 2009, trial balance, the inventory at the
warehouse makes up nearly 80% of the total inventory owned by Lakeside.
Thus, the possibility of a material problem in the inventory held at the stores is
limited. Second, the perpetual records enable the auditors to isolate variances at
all stores which can then be subjected to recounts or further testing if necessary.
Third, Lakeside appears to have an efficient system of taking the physical
inventory. Unless Mitchell and her staff spot weaknesses in the actual
procedures in use, the efficiency of this system offers assurance that the count in
each store has been accurate.
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(6)
One method of manipulating net income is to record sales in one year with
recognition of any subsequent returns being delayed until the following period.
Normally, this problem is overcome by a year-end adjustment to establish an
estimation of all subsequent returns. As evidence of the validity of this
estimation, the auditor will review any sales returns received at the beginning of
the new year. The auditor should be aware that companies can alter reported
earnings significantly by shipping out large quantities of inventory at the end of a
year knowing that most of the items will be returned. If the shipments are
recorded immediately as sales, while the returns are estimated based on
historical data, the company can overstate current income.
(7)
(8)
This question can generate debate among students who often expect the
auditors to perform extensive auditing procedures in regard to damaged and
obsolete merchandise. In reality, Mitchell's role is that of an observer; damaged
or obsolete inventory is the client's responsibility. The Lakeside memorandum
clearly indicates that company employees should separate these items prior to
the inventory count.
Mitchell will want to verify that all damaged or obsolete inventory items have
been segregated and correctly valued. If she is convinced that such inventory
has been isolated, she needs only to ascertain that the value has been
appropriately established by the company. If Mitchell is not satisfied by the
method used to value these items, especially if the total is material, she has the
option of calling upon an independent appraiser to assist her in substantiating the
valuation process.
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(9)
Lakeside's procedures for taking its physical inventory seem well designed
especially since perpetual records are available for comparison purposes. By
following the process outlined in Exhibit 8-1, the company should be able to
arrive at an accurate ending inventory figure.
(1)
An audit program designed to verify the inventory listing and the reconciling items
would include steps such as the following:
a. Trace the tags recorded by the auditor (Exhibit 8-3) to the physical
inventory listing (Exhibit 8-4), noting agreement as to description and
quantity.
b. Verify that no tags were added to the inventory listing beyond the last tag
recorded by the auditor.
c. For each of the inventory items recorded by the auditor, compare the unit
cost indicated on the inventory listing with the cost per the master price list
(Exhibit 6-6). Note agreement as to description as well as unit cost. (Note:
Students may choose to select a new sample for this and the remaining
tests. The advantages to using the same sample throughout are that
recording on the working paper may be simplified and efficiency gained.)
f. Using the master price list, compute a cost for the January 1-2, 2010,
receiving reports. Compare this total to the inventory listing for agreement.
g. Using the master price list, compute a cost for the January 1-2, 2010, bills
of lading. Compare this total to the inventory listing for agreement.
h. Review the inventory listing to ascertain that all tag numbers are included
with no duplications.
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case, this step will not be possible for the students to perform.)
k Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger
at December 31, 2009.
(2)
One technique for approaching this case is to assign Question (1) for one class
period with the working paper to be prepared only after review of the students'
audit programs. This procedure helps to stress the connection between preparing
an audit program, evidence gathering, and developing a working paper. It
demonstrates a continuum from:
In reviewing the audit documents prepared by the students, the instructor should
insist that each specific audit procedure be spelled out along with the results of
that testing. As always, the working paper should be clear and complete, but it
must also indicate the fulfillment of each audit program step.
The attached working paper has been created as an example. It was produced
to correspond with the audit procedures outlined in Exercise (1). In completing
this assignment, procedure (i) has not been performed because the information
was not made available in the case. In addition, the working paper has been
prepared under the assumption that all goods are sold f.o.b. shipping point and
all purchases are acquired f.o.b. destination. These assumptions have been
made to simplify the audit testing, but the students may want to discuss the
additional procedures that would be required if other f.o.b. points had been
appropriate.
88
Lakeside Company WP # F-3 p. 1
Tests of Inventory Listing--Warehouse Prepared by: PR
12/31/09 1/12/10
Reviewed by:
Audit Objectives:
• To verify that the physical count she observed agrees with the inventory
listing.
• To verify that the inventory listing provides a fairly presented inventory cost
balance.
Scope: Items that were selected during the inventory observation. See WP F-1 and F-2.
Audit Procedures:
Traced items to inventory listing noting agreement as to description and quantity.
No exceptions noted.
∅ Traced items from inventory listing to master price list noting agreement as to
description and unit cost. No exceptions noted.
⊗ Recomputed extensions on inventory listing. No exceptions noted.
Other Procedures:
• Agreed last tag (#152) on inventory listing to WP F-1.
• Footed inventory listing. No exceptions noted.
• Accounted for sequence of tag numbers on inventory listing. No exceptions or
duplicates noted.
89
Lakeside Company WP # F-3 p. 1
Tests of Inventory Counts--Warehouse Prepared by: PR
12/31/09 1/12/09
Reviewed by:
Audit Objective:
To verify that the reconciling items to the inventory listing are valid and reasonable.
Scope:
All reconciling items to the inventory listing.
Audit Procedures:
• Agreed quantity and description to WP F-1. No exceptions noted.
• Agreed to master price list noting agreement as to description and unit cost. No exceptions
noted.
@ Agreed to inventory reconciliation.
Other Procedures:
• Recomputed discounts on inventory reconciliation without exception.
• Footed inventory reconciliation without exception.
• Inventory adjustment of $6,156.78 is immaterial. Pass further work.
90
WP # F-1
Prepared by: PR
Date: 1/12/09
Lakeside Company
RECONCILIATION OF
PHYSICAL INVENTORY - WAREHOUSE
January 3, 2010
Audit Objective:
To verify that the inventory balance is valid and reasonable.
Scope:
The listing to the inventory balance reconciliation.
Procedures:
@ Agreed to Inventory Listing
F Footed
R Recalculated
A Agrees to T/B
Audit Conclusion: The inventory balance is fairly stated.
91
CASE 9
(1)
Any company which does not maintain an extensive accounting staff will often
rely on the independent auditors for information concerning the application of
authoritative pronouncements. Most CPA firms assume some responsibility for
keeping client companies aware of important accounting standards and the
potential effects on financial reporting. Thus, Rogers' lack of knowledge about
Statement 34 is not unusual; a bigger surprise might be that the company's
auditors had not previously discussed the requirement with this client.
(2)
Where possible, expense accounting follows the matching principle which states
that expenses should be recognized in the period in which they assist in
generating revenues. An asset produces no revenues prior to being placed into
service. Therefore, any expense recognition (such as depreciation or interest)
would be inappropriate during construction. Only after the asset is in use
generating revenues, should any related expense be recorded.
(3)
(4)
92
students in analyzing this case. Paragraph 29 of this pronouncement states:
After reading FASB Statement 13, students may argue that the lease is actually
for a number of years (probably the life of the building) and that the proposed
series of one-year contracts is only a sham to create the appearance of an
operating lease. In reality, the lease (or so this argument would go) is for over
75% of the economic life of the property. However, if new lease payments are to
be negotiated each period (or if Lakeside intends to stay for only a short time in
that location), a legitimate economic reason may exist for this arrangement.
Unless Lakeside can show such a rationale for the one-year leases, the auditor
will probably use the "actual" life of the lease as justification for requiring
capitalization.
The auditors also need to verify that the $21,000 payment for the building has not
been "significantly affected" by the relationship between Lakeside and Rogers.
Abernethy and Chapman will want to learn how this figure was determined and,
perhaps, seek information about rental rates for similar property in the vicinity of
that store. Rogers states that "the price is quite reasonable for that store at that
location," but his opinion does not provide the auditors with much assurance.
93
(5)
(6)
The potential impairment of value of Store Six has been an underlying problem
throughout the Lakeside audit. In discussing this issue, students frequently
concentrate on the wrong issues: client retention versus safety from litigation.
Audit opinions, however, should be based on the actual evidence accumulated
and the related reporting employed by the client, not on the avoidance of
problems. Such a limited approach fails to recognize the auditor's function: to
gather corroborative evidence on which to base an opinion as to the fair
presentation of the financial statements. Virtually no corroborative evidence is
presented in these cases in connection with Store Six and its potential
impairment of value; therefore, students have no basis for any specific course of
action. In practice, auditors first gather as much evidence as possible and only
then do they make a final determination when faced with this type problem.
Students can be asked to list the kinds of evidence Abernethy and Chapman
might seek in evaluating the possibility of a material impairment of value in
connection with Store Six. This exercise is a good technique for demonstrating
the necessity of creativity in the auditor's work. The auditor needs to consider all
possible ways to gain assurance about the future of this store. A few of the
evidence-gathering procedures that might be carried out would include:
• Discussion with the owners and managers of the shopping center as to their
strategies for renting more space and improving customer traffic.
• Talk to owners and managers of the stores located in the shopping center
to see whether their projections are similar to those of Rogers.
• Search for any studies that have been prepared on the consumer
94
electronics business which might a) project a break-even point for a store or
b) assess the risks involved in the failure of a single outlet.
• Hire a real estate appraiser to estimate the sales value of the building if it
should have to be sold. This valuation will enable the auditor to anticipate
the potential loss being faced by Lakeside.
One final point should be made in connection with this potential impairment of
value. The implication is made throughout these cases that the primary
responsibility for resolving this issue lies with the auditors. That is not correct.
The financial statements are representations of the management of the client
company. As such, management is responsible for justifying the financial
reporting. Unless Rogers makes a significant attempt to prove his present
position in this controversy, the auditors will have trouble rendering an
unqualified opinion.
(7)
Little doubt exists that Rogers has issued a subtle threat to the new audit firm.
One of the primary reasons for investigating the integrity of management prior to
accepting an engagement is to avoid the possibility of this type of blackmail. This
warning was issued in such a way by Rogers that Abernethy and Chapman will
probably not need to consider the possibility of resigning but, if a similar threat is
ever made in an overt manner, immediate resignation by the CPA firm should be
considered.
(1)
95
LAKESIDE COMPANY W.P. I-3
Building-Warehouse/Office A/C 111-1 2
12/31/09 Accountant: AH
Date: 1/14/10
Audit Procedures:
∅ Traced to 12/31/08 audited balance per predecessor auditor's audit documents noting agreement.
(Note: Although necessary, this procedure cannot be performed with the information given in this
text.)
Traced to general ledger noting agreement. Also, traced to purchase invoice noting agreement as
to amount, and approval.
96
LAKESIDE COMPANY W.P. I-3
Building - Warehouse/Office A/C 111-1 1
12/31/09 Accountant: AH
Date: 1/14/10
PROPOSED ADJUSTMENTS
C Invoice for work done 12/28/09-1/8/10 by Gainer Electrical Company received after year-end.
Accrue four days (4/12 x $4,800= $1,600).
AJE 3
111-1 Building-Warehouse/Office 1600-
210-2 Accounts Payable 1600-
D Capitalize interest on building loans. This figure is roughly estimated based on the expenditures
on construction (from "subtotal" on previous page) of $93,800, the interest rate charged on the direct loan,
10%, and the time of construction during 2009 (3 months from October to December, per the invoices in
Exhibit 9-6). Thus, $93,800 x .10 x 3/12 = $2,345.
AJE 4
111-1 Building-Warehouse/Office 2345-
220-1 Accrued Interest Payable 2345-
AJE 5
New Construction in Progress-Warehouse 96145-
acct.
111-1 Building-Warehouse/Office 96145-
Audit Conclusion: Account is fairly stated, after adjustments, in accordance with GAAP.
97
SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS
(1)
The SEC may make exemptions for certain individuals on a case-by-case basis. The audit
committee of an issuer shall be directly responsible for the appointment, compensation,
and oversight of the work of any registered public accounting firm employed by that
issuer. The audit committee shall establish procedures for the "receipt, retention, and
treatment of complaints" received by the issuer regarding accounting, internal controls,
and auditing. Each audit committee shall have the authority to engage independent
counsel or other advisors, as it determines necessary to carry out its duties.
Each issuer shall provide appropriate funding to the audit committee.
(2)
The CEO and CFO of each issuer shall prepare a statement to accompany the audit report
to certify the "appropriateness of the financial statements and disclosures contained in the
periodic report, and that those financial statements and disclosures fairly present, in all
material respects, the operations and financial condition of the issuer." A violation of this
section must be knowing and intentional to give rise to liability.
98
CASE 10
(1)
Thus, some amount of risk is tolerated in the testing procedures being applied.
Statistical sampling allows certain aspects of that risk to be measured
mathematically. Auditors use statistics to determine the number of items that
should be examined to reduce sampling risk to a level that is considered justified.
(2)
Statistical sampling does not create additional work; rather, it guides the auditor
in performing the proper amount of work. In addition, although statistical
sampling may initially appear to be complex, the various procedures become
significantly easier with practice.
99
highest rate at which reliance can be justified. All of these considerations are
important in applying this audit procedure. The statistical sampling plan being
used by Abernethy and Chapman requires the auditor to consider each of these
limits before testing can begin.
(3)
(4)
Mitchell is seeking to verify that a proper cut-off has been performed by the client
in recording its year-end accounts payable and accrued expenses. In this
process, a number of invoices are to be reviewed to ensure that Luck has
appropriately determined the amount owed by Lakeside on December 31, 2006.
At the same time, the auditor can also ascertain that a purchase requisition has
been prepared for each of these invoices. Mitchell may also elect to examine the
invoices to determine if physical evidence exists to indicate that each document
has been mathematically proven and properly authorized by company personnel.
Thus, several testing procedures can be carried out simultaneously by the audit
team.
(5)
Once again, as in question (1), the auditor is seeking only reasonable, not
absolute, assurance about the fair presentation of the client's financial
statements. Thus, the presence of some errors, especially if they are not
material, does not necessarily nullify the value of the information. In addition, the
auditor rarely relies exclusively on the work of one particular individual in making
an assessment. Luck's analysis will provide evidence about this expense
accrual, but other testing should be carried out before the audit team is satisfied
that the account balances are fairly presented.
Luck might commit mistakes for a number of reasons, most of which involve
human errors caused by carelessness, fatigue, misunderstanding, etc. She may,
for example, misread an invoice or miscalculate the amounts involved. She
100
could also omit an invoice entirely or include one a second time by accident. The
possibility also exists that Luck might have purposely misrepresented the year-
end accrual as a way of manipulating the income figures to be reported by the
company.
(6)
In most examinations, previous experience with the client and its personnel will
assist the auditor in arriving at an estimation of an actual exception rate.
However, the firm of Abernethy and Chapman has not audited Lakeside in the
past; thus, Mitchell must rely more heavily on other techniques. To begin, she
should ascertain the difficulty of the task being performed. She will also have
had the opportunity to observe Luck's work throughout the engagement and
should hold some opinion as to the reliability of this employee. She may do a
pilot test, choosing a relatively small random sample to see what the sample
exception rate is. Finally, from experience with other clients, the auditor can
usually anticipate an exception rate for a particular task.
(7)
(8)
According to Exhibit 10-2, a sample size of 40 (left column) with 2 errors (top
row) indicates a maximum error rate of 12.8% with a 10% ARACR. Since
Mitchell has specified a tolerable exception rate of only 6%, she cannot accept
the client's work as a fair representation of the amount of the year-end accrual.
The client's total accrual figure may, indeed, still be accurate, but the sample
indicates the possibility of too many errors for the accrual to be judged as
reliable. The error rate indicates that the risk level is too high for auditor
acceptance without additional testing.
101
(9)
In most cases, the auditor would now seek to apply other procedures to verify the
reported balance. The client might, for example, be requested to reconstruct the
accrual with the newly derived balance then being tested, again using sampling
for attributes. However, because of the small population size in this case,
Mitchell may simply resort to reviewing all 283 invoices to achieve adequate
assurance about the accrual. After analyzing the entire population, the auditor
can either accept the client's accrual or propose an adjustment.
(1-a)
102
Each individual invoice and the accrual established for it as of
December 31, 2009.
(5) Specify the acceptable risk of assessing control risk too low and discuss
any factors affecting this decision:
10%
(No information is presented in this case to indicate how this risk level
was derived. This is typically either 5% or 10%).
(6) Estimate the exception rate of the population, and discuss any factors
affecting this estimation:
3%
(Discussion Question 6 above examines the factors that should have
influenced this estimation.)
(7) Specify the tolerable exception rate and discuss any factors affecting this
decision:
6%
(Discussion Question 7 above examines the factors that should have
influenced this parameter.)
(8) Indicate the sample size and show the use of the finite correction factor if
applicable:
90
Exhibit 10-1 is appropriate for a 10% ARACR. The expected
population deviation rate of 3% is found in the left column with the
tolerable deviation rate of 6% found across the top. These two figures
intersect at a sample size of 132.
(10) Indicate the number of deviations discovered, the rate of deviations in the
sample, and the upper deviation rate in the population:
103
Two errors were discovered;
the sample exception rate is 2.2% rounded (2/90); and
from Exhibit 10-2, two deviations found in a sample of 90 items indicates
a maximum rate of 5.8% (CUER) with a 10% ARACR.
With a 10% ARACR, the sample indicates that Luck's accrual of year-
end expenses has a CUER of 5.8%.
The two errors are of relatively small amounts and appear to be caused
by mathematical mistakes.
(13) Recommendations:
(1-b)
If three errors were found, then the results for questions (10) through (13) of
Exhibit 10-3 would be different. With three errors, the sample exception is 3.3%
rounded (3/90); and from Exhibit 10-2, three deviations found in a sample of 90
items indicates a CUER of 7.3% with a 10% ARACR. Since the tolerable rate was
6%, her work should not be considered reliable based on the number of errors it
contains.
104
CASE 11
(1)
Statistical sampling requires the auditor to establish risk parameters prior to the
start of a testing procedure. Thus, a desired level of assurance (and, conversely,
an acceptable level of risk) is always defined whenever statistical concepts and
mathematical formulas are to be utilized. The auditor is aware in advance of the
possibility of a mistaken conclusion. Such information is especially important if
the audit firm ever has to justify its examination and the opinion rendered.
However, application of statistical sampling does demand a specialized degree of
knowledge. The auditor must have an adequate understanding of statistical
methodology. In addition, developing a statistical sampling plan may require a
significant amount of audit time.
Judgmental sampling is many times easier and quicker to apply and is, thus,
especially appealing in audit areas where exact precision is not required. For the
auditor with sufficient experience, this type of sampling can frequently provide
satisfactory conclusions about much of the client's data. Unfortunately, since no
guidelines exist for key decisions such as acceptable risk levels, required sample
size, or the evaluation of final results, the auditor has no way of measuring the
potential for an incorrect assessment. In any test, not enough items may have
been examined to support a conclusion, or too much testing could occur creating
an inefficient audit. Furthermore, if the auditor must ever demonstrate in a peer
review or court case the basis for a particular decision, objective evidence to
substantiate the judgment is usually not available.
(2)
105
in charge of this audit, and he should never accept a client figure until personally
satisfied of its fair presentation.
(3)
• The auditors had to decide whether to test the 283 invoices by sampling or
by examining the entire population.
• The auditors had to choose between applying sampling for attributes to
evaluate the client's expense accrual or some type of sampling for variables
plan.
• The auditors had to establish an acceptable risk of incorrect acceptance.
• The auditors had to establish an acceptable risk of incorrect rejection.
• The auditors had to set a tolerable misstatement, the amount of error the
firm was willing to accept in the reported balance.
• The auditors had to decide which type of sampling for variables plan would
be used; both mean-per-unit and difference estimation were discussed in
this case. Monetary unit sampling and stratified mean-per-unit sampling
are just two of the other techniques used by auditors.
• The auditors had to select a point estimation of the population error.
• The auditors had to choose a method for randomly selecting the items to be
sampled.
(4)
In the competitive times that now preside over the public accounting profession,
the auditor cannot afford to rely on unnecessarily slow and time-consuming
techniques. More importantly, though, the auditor can never afford to do an
examination in less than a quality manner. Using judgmental sampling simply
because it may be faster is a shortsighted approach. Each audit must be
performed appropriately regardless of the amount of time involved.
Because of the time pressures present in modern auditing, each auditor needs to
possess a ready knowledge of statistical sampling techniques so that the
efficiency of their use can be increased substantially. Certainly, any procedure is
106
time-consuming if the auditor's understanding is limited. Through education and
the utilization of devices such as preprinted forms and computers, statistical
sampling plans can be carried out in a minimum of time. However, the auditor
should continue to be alert to situations where judgmental sampling can be
applied. Not every test warrants the use of statistical sampling, and the auditor
needs to be capable of drawing this distinction.
(5)
As is shown by Cases 10 and 11, the distinction between sampling for attributes
and sampling for variables is not always as clear-cut as the previous paragraph
implies. In Case 10, sampling for attributes was used to verify Luck's expense
accrual, whereas sampling for variables was utilized in Case 11 for this same
purpose. The auditor must always determine the objective of a specific test and
evaluate which type of testing will achieve that goal in the most efficient manner.
(6)
Given the risk parameters that have been established by the auditor, the actual
total of the differences in the client's population is estimated to lie between an
understatement of $8,960 ($3,760 + $5,200) and an overstatement of $1,440
($3,760 -$5,200). Since the auditor wants assurance that the client figure is
within $8,000 of the real total, the firm cannot accept the $46,311 as fairly
presented. The $8,960 estimation derived from the sample lies outside of the
acceptable boundary. The client total may still be appropriate, but this sample
indicates that too much risk exists to accept the balance without further testing.
107
SUGGESTED ANSWERS TO EXERCISES
(1)-(A)
(1) - Estimate the standard deviation of the population. Show the formula being
used and identify each element within this formula.
∑( e) − n( e )
2 2
e (e)2
205 42,025
49 2,401
(110) 12,100
156 24,336
300 80,862 ē = 300/30 or 10
108
80,862 − 30 (10 )
2
(2) - Specify the acceptable level of risk for incorrect acceptance. Identify the
confidence coefficient (Z value) for this percentage. Include any
considerations that were used in arriving at this parameter:
The risk of incorrect acceptance was set at 10% but no information was
provided in this case to indicate the rationale for this decision. The Z
Value for a 10% risk of incorrect acceptance is 1.28 according to Exhibit
11-1.
(3) - Specify the acceptable level of risk for incorrect rejection. Identify the
confidence coefficient (Z value) for this percentage. Include any
considerations that were used in arriving at this parameter:
The risk of incorrect rejection was set at 30% but no information was
provided in this case giving the rationale for this decision. The Z value
for a 30% risk of incorrect rejection is 1.04 according to Exhibit 11-1.
(5) - Specify a point estimate of the population error. Describe the method by
which this determination was made:
(6) - Calculate the appropriate sample size. Show the formula being used and
identify each element within this formula:
SD × ( Z a + Z r ) × N
2
Sample size =
TM − E
Where:
N is the population size
Za is the confidence coefficient for the acceptable risk of incorrect
acceptance
Zr is the confidence coefficient for the acceptable risk incorrect rejection
109
SD is the estimate of the standard deviation of the difference
TM is the tolerable misstatement of the population
E is the point estimate of the population misstatement
(1)-(B)
(4) - Specify the acceptable level of risk for incorrect acceptance and identify the
confidence coefficient (Z value) for this percentage:
(5) - Specify the acceptable level of risk for incorrect rejection and identify the
confidence coefficient (Z value) for this percentage:
110
Risk of incorrect acceptance is 30% with a confidence
coefficient of 1.04.
$8,000
$2,830
(10) - Recompute the standard deviation using the entire sample selected:
n −1
Where:
e is the value of each unit sampled
ē is the average of each unit sampled
n is the number of units sampled
All 50 items sampled in Exhibit 11-2 and 11-3 show 43 differences with
a zero balance and seven with either positive or negative balances.
e (e)2
205 42,025
49 2,401
(110) 12,100
156 24,336
(97) 9,409
(150) 22,500
47 2,209
100 114,980 ē = 100/50 or 2
111
114 ,980 − 2( 50 )
2
(11) - Calculate the average difference within the sample and extend this figure
to the entire population:
(12) - Determine the precision interval. Show the formula being used and identify
each element within this formula (all computations should be attached):
SD N −n
Precision Interval = N ×Za × ×
n N
48 283 − 50
Precision Interval = 283 ×1.28 × × = $2,238
50 283
(13) - Identify the upper and lower confidence limits of the population based on
the precision interval and the average difference of the sample:
(14) - Conclusions/Recommendations:
No portion of the computed range of total errors falls outside of the $8,000
112
tolerable error limit. The client's accrual should be accepted as a fair
representation of the year-end liability.
113
CASE 12
(1)
* Review of the checks clearing the bank during the first few days of the new
year. Clearance of these checks serves as evidence of the validity of the
"outstanding checks" total included in the client's year-end bank
reconciliation. Any check which is not returned by this time may have been
falsified to cover a cash shortage.
* Review of the specific date on which each returned check cleared the bank.
This procedure serves as a means of ascertaining the appropriateness of
the year-end cut-off made of cash disbursements.
* Identification of all inter-bank transfers made near the end of the year so
that they can be scheduled in assessing the possibility of check kiting.
* Review of all deposits clearing the bank during this cut-off period as proof of
the "deposits-in-transit" figure on the year-end reconciliation.
114
* Verification of the bank balance included in the year-end cash
reconciliation.
(2)
Many thefts and other illegal acts are perpetrated through the use of bank
accounts that supposedly have been closed. For example, a dishonest
employee can utilize such an account to cash checks made out in the name of
the company. The check is first deposited in this account followed by a
subsequent withdrawal by the employee. In a different vein, the company itself
could use a "closed" account to hide illegal payments or other transactions from
the auditors. To gain evidence of the possibility of such actions, a confirmation
should be used to obtain final information about any bank account that has been
closed by the client during the current year.
(3)
b. Fire Damage - Although the fire occurred subsequent to the fiscal year,
Statement on Auditing Standards 1 specifies that some events happening
after the end of the period "may be of such a nature that disclosure of them
is required to keep the financial statements from being misleading." SAS 1
goes on to list a number of examples, including inventory destroyed by fire.
Thus, Lakeside's 2007 fire loss will probably require disclosure in the 2006
financial statements.
115
2009.
(4)
For many companies, a number of transactions occur within two or three days of
the end of the fiscal year. In seeking evidence of the fair presentation of the
financial information, the auditor needs to ensure that the impact of these
transactions is recorded in the proper time period. Cut-off testing is designed to
accomplish this goal. Reporting problems are especially likely if the client's
accounting system is not able to adequately classify the sheer volume of
transactions that can occur at year's end. In addition, the auditor must be aware
that company management can manipulate reported net income by having the
cut-off made either a few days before or a few days after the end of the period.
(5)
116
(6)
Contingent losses such as those arising from law suits or the possible closing of
a store are frequently quite material in size. Thus, the auditor is usually faced
with a potential outcome that can have an enormous impact on reported financial
figures. Furthermore, the ability of the auditor (or anyone else) to foresee the
future resolution of such contingencies is largely speculation. In the audit of
Lakeside, for example, the loss from Store Six may never occur or it may amount
to as much as $186,000. The auditor is being forced to evaluate the reporting of
possible future outcomes, data that is not easily subjected to attestation. Finally,
contingent losses are not always easy to uncover. Unasserted claims, for
example, may generate little or no documentation by the client until a formal
claim is made. Therefore, the auditor must perform a thorough investigation in
hopes of revealing any contingencies that might otherwise go unreported. In
seeking evidence of these losses, the auditor will talk with the client
management, read the minutes of stockholders' meetings as well as the
meetings of the board of directors, check contracts and disputed transactions,
read correspondence with lawyers, and review all bank confirmations.
(7)
As with any confirmation, the letter of inquiry to the legal counsel must be
prepared and signed by the client but mailed by the audit firm. The confirmation
should direct the recipient to send all responses to the auditor who is attempting
to gain assurance about the existence, evaluation, and reporting of both asserted
and unasserted claims against the client company. The inquiry letter lists all
pending or threatened litigation identified by the client along with management's
evaluation of the current status of these actions. The list should be limited to
claims for which the law firm has devoted substantial attention so that a proper
evaluation can be made. The counsel is requested to furnish information as to
the nature of each matter, progress to date, likelihood of an unfavorable
outcome, and the range of potential losses. The legal firm is also asked to
identify any other asserted claims against the client that are known to exist.
Finally, the letter requests the law firm to identify the nature and reason for any
limitations in the response to these inquiries.
117
(8)
The discovery and assessment of pending and threatened litigation has long
been an area of contention between the auditing and legal professions.
Traditionally, the independent auditor has looked to the client's attorney for
information to help evaluate these contingent losses. The legal profession has
often protested such inquiries for a number of reasons. One objection is that any
communication between the attorney and the auditor may be construed as a
breach of the confidentiality that exists between the attorney and the client.
Having broken the confidential nature of the relationship, attorneys risk not being
able to avail themselves of this privilege in the future. In addition, the question
has been raised as to whether the attorney could incur any liability if the
assessments provided to the auditor proved to be incorrect. Finally, attorneys
are cognizant of the effect upon client retention if they should reveal information
to the auditor which the client did not want disclosed.
Auditors search for all possible contingent losses which would then be evaluated
by the client. The client would describe these contingencies in a letter to the
company's legal counsel. The losses were to be split between "pending or
threatened litigation" and "unasserted claims and assessments." In response to
the first category, the attorney was to inform the auditor of any omissions or any
disagreements with the client's evaluations. For unasserted claims and
assessments, the attorney was asked to inform the auditor only of disagreements
with the evaluations. If unasserted claims were omitted, the attorney would
advise the client of the necessity of making appropriate disclosure. If the client
then refused to report this information, the attorney was instructed to consider
withdrawal by resignation.
(9)
118
(10) and (11)
In order to arrive at an estimation of the product warranty expense for 2006, the
auditors must certainly look at the past history of the company as mentioned in
this case. A schedule can be determined from the information given of the
expense incurred during the previous months. However, the auditors cannot be
satisfied with that evidence alone. Abernethy and Chapman should look for
factors that would cause the future repairs of the company to differ from the past.
For example, in scheduling the past repairs, the auditors need to watch for any
trends that are evident. Repair costs (such as labor or parts) might have begun
to climb recently or the incidence of product failure could be falling. Such trends
affect the calculation of the client's present liability.
The auditors should also look for other changes that are occurring that might
have an impact on this estimation. Some products, as an example, might be
more likely to break. If so, the auditors should determine if sales of those items
were growing or decreasing. A call to Cypress Products could provide valuable
data as to the repair rate for various items. This company, most likely, will
monitor closely the need for repairs. In addition, publications such as Consumer
Reports often provide statistics on the likelihood that products will fail. For
example, radios may break more often than stereo systems and, thus, require a
different percentage for estimation purposes.
Finally, the auditors will want to review the repair costs incurred during the
approximately seven weeks following the end of the fiscal year. If repair costs
jump during the subsequent period, Abernethy and Chapman may need to raise
their estimation. However, if costs are being held at a minimum, the accrual
should be decreased.
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SUGGESTED ANSWERS TO EXERCISES
(1)
An additional factor in this case concerns the structuring of the data. Quite often,
the client will have accumulated information in a manner that is not relevant to
the needs of the auditor. Lakeside has classified its repair expense by the month
in which the item is returned while the auditors want to match the expense with
the month in which the item is sold. Therefore, a necessary step in establishing
the appropriate accrual is the restructuring of the data as is demonstrated in the
attached working paper. This worksheet presents one method of computing the
estimated repair accrual as of the end of 2009. The computation indicates that
Lakeside's accrued expenses are actually $24,675 too high; the adjustment will,
therefore, increase the company's net income by this amount.
A final point which may deserve some class discussion is the necessity of
verifying the client's data. To avoid making the case overly complex, the client's
figures have been used for this estimation without any testing. By now, the
students should realize that such immediate acceptance is inappropriate. The
auditor will have to ascertain the validity of this information before relying on it for
this computation.
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LAKESIDE COMPANY W.P. No. M-4
Estimated Accrued Product Warranty Expense 1
December 31, 2009 Accountant:
AH
Date: 2/2/10
Audit Objective:
To estimate the accrued product warranty expense as of Dec. 31, 2009.
Audit Procedures:
Comments:
A Historical data for the months from January 2008 to June 2009 (18 months) are being used to develop
an estimate of monthly repairs expense. This estimate will be applied to the last six months sales of 2009
to determine the year end accrual. During the 18-month test period, repair expenses showed a gradual
increase from .72% to .90% of sales. Because of this upward trend, it is recommended that Lakeside use .
95% of sales for estimating repair expenses for the last six months of 2009.
B Sales during the last six months of 2009 are still under warranty. These sales total $3,601,500 for an
estimated repair expense of $34,214 based on .95% (see A above). During the last six months of 2009,
$13,424 in repairs were made in connection with these sales. As of December 31, 2009, an estimated
liability of $20,790 (=$34,214-$13,424) remains. Lakeside's accrual of $45,465 should be adjusted
($45,465 recorded balance - 20,790 desired balance =$24,675 overstatement).
Audit Conclusion:
Accrued product warranty expense is fairly stated, after adjustment, in accordance with GAAP.
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LAKESIDE COMPANY W.P. No. M-4
Estimated Accrued Product Warranty Expense 2
12/31/09 Accountant: AH
Date: 2/2/10
A: Sales not under warranty
Historical Data 1/08 2/08 3/08 4/08 5/08 6/08 7/08 8/08 9/08 10/08 11/08 12/08
Sales for month 582000 316000 359000 479000 486000 414000 371000 460000 442000 533000 586000 800000
Repairs:
Month of Sales 193 137 177 222 147 61 256 284 210 292 469 505
1 month after 533 388 329 369 514 276 313 497 559 583 563 948
2 months after 837 319 481 480 625 429 569 462 629 666 657 885
3 months after 875 662 658 591 441 797 541 639 664 917 845 1074
4 months after 343 320 456 702 1029 735 512 604 594 625 798 1203
5 months after 571 205 228 812 698 490 456 675 699 500 657 1030
6 months after 457 251 202 517 220 272 199 391 140 583 704 695
Total repair expense 3809 2282 2531 3693 3674 3060 2846 3552 3495 4166 4693 6318
Repair expense as a .72% .72% .71% .77% .76% .74% .77% .77% .79% .78% .80% .79%
percentage of sales
Historical Data Cont. 1/09 2/09 3/09 4/09 5/09 6/09 7/09 8/09 9/09 10/09 11/09 12/09
Sales for month 610500 381000 346000 557000 590000 409000 422000 550000 511000 602500 642000 874000
Repairs:
Month of Sales 323 336 234 335 421 368 599 251 277 220 423 504
1 month after 969 366 351 670 736 442 337 752 738 769 785
2 months after 861 397 410 766 684 516 375 1203 830 934
3 months after 915 580 527 1054 947 664 749 852 876
4 months after 1028 549 292 718 1894 627 824 602
5 months after 808 519 468 575 999 553 524
6 months after 485 305 644 670 579 516
Total repair expense 5884 3052 2926 4788 5260 3686 3408 3660 2721 1923 1208 504
Repair expense as a .88% .80% .85% .86% .89% .90%
percentage of sales
13,424 returns to date for products still with warranty.
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(2)
This question has been included to emphasize the audit report as the end
product of the auditor's work. As this text has been an exploration of the attest
function rather than a full-scale audit, determination of an appropriate opinion for
2009 is not feasible. Presented below are two possible conclusions for this case.
The first is based on an unqualified opinion on the 2009 statements because
Abernethy and Chapman either believes the potential impairment of value on
Store Six is not material, or that its likelihood is only remote. The second
possible conclusion is that disclosure is needed in connection with the problems
encountered with Store Six, and that Rogers is unwilling to make this disclosure.
In both cases, the assumption is made that King and Company, the predecessor
auditor, continues to believe that a qualified opinion is still appropriate for the
2008 statements. Since comparative statements are being published, Abernethy
and Chapman also have to provide information about this previous opinion.
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UNQUALIFIED OPINION
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QUALIFIED OPINION
In our opinion, except for the effects of not recording or disclosing the
impairment of value of the asset, as discussed in the preceding paragraph, the
aforementioned financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 2009, and the
results of its operations and its cash flows for the year then ended in conformity
with accounting principles generally accepted in the United States of America.
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CASE 13
(1)
(2)
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Abernethy and Chapman has employed an appropriate system for educating the
client. Klontz is developing and will present a series of potential, clearly-defined,
functions that could be computerized. Thus, Rogers will be able to analyze the
possibilities that are offered by an automated system and judge for himself as to
which are worth the costs that are involved.
(3)
Public accounting firms come into contact with numerous business organizations,
their operations, and their accounting systems. Since the client's systems and
controls must be understood as a part of the attest function, the auditor has
always been in a position to note and propose improvements. Hence, the
opportunity and the expertise are both naturally in place to provide advisory work.
In recent years, such advice has become more formalized as firms have begun
to offer a wide range of services to clients as well as to other organizations.
During the last two decades, CPAs have come to recognize such work as a
lucrative offshoot of the public accounting profession.
(4)
A fully computerized accounting system has two major impacts on the work of
the independent auditor. First, the traditional audit trail is changed significantly.
The series of paper documents that could be followed from the inception of a
transaction to its final recording is often unnecessary in an automated system.
The information is entered into the computer so that no tangible record of
changes and events necessarily exists.
Second, computer processing does not utilize the same control procedures
commonly found in a manual system. For example, in manual systems, one
individual is frequently assigned to review and authorize the work of another
employee, a verification task not necessarily required by a computer.
Consequently, when an automated system is in use, the internal control must
take on new, sometimes creative, forms.
Because of the lack of an audit trail and the presence of different control
procedures, the audit firm must adapt its examination to new circumstances.
Increased emphasis is placed on developing tests of the computer controls to
ensure that all of the data being processed is reliable. The auditor would expect
the computer installation, for example, to have restricted access to limit the
possibility of unauthorized changes. Where direct input into the computer is
allowed, pass codes should be used for this same purpose. A control group also
needs to be created to monitor all computer processing and its output. In
addition, the client should require the use of control totals (batch totals, item
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counts, or hash totals) to provide evidence of the accuracy of information
produced by the computer system. Periodically, the programs in use should be
rechecked for unauthorized alterations.
Public accounting firms have long held that a distinction is maintained between
consulting and audit services, a separation that protects them from any possibility
of a conflict of interest. In many organizations, the two services are offered
through relatively autonomous divisions. Furthermore, the client is free to
discuss possible improvements with any other business enterprise providing
these services. Many large companies, for example, use one firm for auditing
and a different organization for advisory services to avoid becoming too
dependent on any one group.
The Enron Bankruptcy will have ramifications on auditor independence issues for
many years to come. For example, the Government Accounting Office (GAO)
issued new independence rules dealing with non-audit services performed by the
auditor in governmental audits. Also, the Sarbannes-Oxley Act required that
many of the consulting activities be eliminated for a firm's publicly-traded audit
clients.
(1)
The cases in this book have described several of the accounting systems in use
by the Lakeside Company. Because of the lack of complete computerization,
these various functions are mechanical in design, relying on the skills of the
company's employees. Therefore, Abernethy and Chapman can recommend to
Rogers a number of specific functions to be modernized through the installation
of a new accounting information system. Listed below are a few examples of the
types of suggestions that students may provide:
- Payroll
The names and pay rates for all employees are programmed into the
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computer. At the end of each pay period, the number of hours worked by
every hourly employee is also entered along with sales figures for individuals
being paid on commission. The computer automatically calculates the gross
pay for each employee. The amount to be paid to salaried workers is based
on individual contract rates while the salary for each hourly and commission
worker is determined from the information entered for the period. Federal
and state income tax withholding figures are also computed as well as Social
Security payments and any other payroll deductions. A net wage for each
individual is then derived with the computer printing out the actual
paychecks.
- Credit File
- Perpetual Inventory
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invoices can be mailed or other follow-up procedures instigated.
(2)
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changes being made.
- Testing of all programs should be performed before the client relies on them.
For a time, as an example, the company may want to run parallel processing
where all functions are carried out both manually as well as through the new
information system to ensure that the output is accurate. In addition,
Lakeside should process test (or erroneous) data using the various computer
systems to further verify the reliability of the output.
- Where possible, validity checks could be installed within the various systems
so that data must be verified independently before being processed. A
customer name, as an example, has to be on an approved customer list
before a sale is authorized and merchandise shipped. Likewise, an
individual's identification number must be listed on a master employee file, or
a paycheck will not be produced.
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to zero the need for any type of written information. However, control may be
enhanced by having employees record a limited amount of data at the point
of a transaction solely for reconciliation purposes. As an illustration, a bill of
lading may be produced (manually or by the computer) and sent to the
customer as a verification of a shipment. A copy of this document can
subsequently be used by the company to check the data entered into the
computer.
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