Week 3, Assignment

5-29 (Assertions) In planning the audit of a client's inventory, an auditor identified the following
issues that need audit attention.

1) Inventories are properly stated at the lower of cost or market.

Valuation or Allocation

2) Inventories included in the balance sheet are present in the warehouse on the balance sheet
date.
Existence or Occurrence (Occurrence)

3) Inventory quantities include all products, materials, and supplies on hand.

Existence or Occurrence (Existence)

4) Liens on the inventories are properly disclosed in notes to the financial statements.
Completeness; Presentation and Disclosure

5) The client had legal title to the inventories.

Rights and Obligations

6) The financial statements disclose the amounts of raw materials, work in progress, and
finished goods.
Presentation and Disclosure

7) Inventories include all items purchased by the company that are in transit at the balance sheet
date and that have been shipped to customers on consignment.
Rights or Obligations (Rights to ownership of consignment inventory)

8) Inventories received on consignment from supplier have been excluded from inventory.
Rights or Obligations (Rights to ownership of inventory)

9) Quantities times prices have been properly extended on the inventory listing, the listing is
properly totaled, and the total agrees with the general ledger balance for inventories.
Valuation or Allocation

10) Slow-moving items included in inventory have been properly identified and priced.
Presentation and Disclosure (Accuracy and valuation and Classifications and
understandability)

11) Inventories are properly classified in the balance sheet as current assets.
Presentation and Disclosure

REQUIRED
Identify the assertion for items 1 through 11 above.

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 6-21 (Audit evidence) In an audit of financial statements, an auditor must judge the validity of
the audit evidence obtained.

REQUIRED
a) In the course of an audit, the auditor asks many questions of client officers and employees.
1. Describe the factors that the auditor should consider in evaluating inquiry and oral
evidence provided by client officers and employees.
Evaluating inquiry and oral evidence is less reliable that written or documented
evidence. Observations, inspections and double-checking the mathematical
correctness provides better audit evidence for the auditor's working papers.
However, client inquiries can be helpful because they provide the auditor with insight
regarding the internal controls, risk assessments and audit test determinations.

2. Discuss the validity and limitations of inquiry and oral evidence.

The validity and limitations of inquiry and oral evidence obtained from non-biased
third parties can be useful when researching a firm. The validity of inquiry and
oral evidence can be useful only if it is relevant to the assertion testing. Third
party confirmation of liabilities and receivables can only be used as valid
evidence during the testing process.

b) An audit may include computation of various balance sheet and operating ratios for
comparison to prior years and industry averages. Discuss the validity and limitations of ratio
analysis in an audit.
Ratio analysis is not one of the most reliable forms of evidence due to their nature.
Ratios have a tendency to be very misleading, especially if there were
misclassifications or other areas which may be vague in nature. However,
ratio analysis can help to determine the validity of certain areas such as costs
which can be very useful to the auditor.

c) In connection with his audit of the financial statements of a manufacturing company, an

auditor is observing the physical inventory of finished goods, which consists of expensive,
highly complex electronic equipment. Discuss the validity and limitations of the audit
evidence provided by the procedure.
Auditor's using observation during their audit need to be cautious that observation has
limitations in regards to the time frame in which the observation is taking place. The
internal control procedures may be altered during the observation by the auditor
and may be done only while the auditor is observing. The validity of the audit
evidence depends on the assertion being tested. Inspecting documents that are
accurate but are not fairly represented on the financial statements would not be
valid evidence.

6-22 (Audit evidence) During the course of an audit, the auditor examines a wide variety of
documentation. Listed below are some forms of documentary evidence and the sources from
which they were obtained.

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 a) Classify the evidence by source into one of four categories (1) Directly from outsiders, (2)
indirectly from outsiders, (3) internal but validated externally (4) entirely internal
1. Bank statement sent directly to the auditor by the bank.
(1) Directly from outsiders

2. Creditor monthly statement obtained from client's files.

(2) Indirectly from outsiders

3. Vouchers in client's unpaid voucher-file

(4) Entirely internal

4. Duplicate sales invoices in filled order file

(4) Entirely internal

5. Time tickets filed in payroll department

(4) Entirely internal

6. Credit memo in customer's file

(4) Entirely internal

7. Material requisitions filed in storeroom

(4) Entirely internal

8. Bank statement in client's files

(2) Indirectly from outsiders

9. Management working papers in making accounting estimates

(4) Entirely internal

10. Paid checks returned with bank statement in (1) above.

(3) Internally but validated externally

11. Letter in customer file from collection agency on collectability of balance.

(2) Indirectly from outsiders

12. Memo in customer files from treasurer authorizing the write-off of the account.
(4) Entirely internal

b. Comment on the reliability of the four sources of documentary evidence

The reliability of the sources can be ranked from the most reliable to the lease reliable as
follows:
Directly from outsiders (most reliable)
Indirectly from outsiders
Internal but validated externally
Entirely internal (least reliable)

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 7-16 (Accepting the engagement) Sunny Energy Applications Co. sells solar-powered
swimming pool heaters. Sunny contracts 100 percent of the work to other companies. As Sunny
is a new company, its balance sheet has total assets of $78,000, including $24,000 of "stock
subscriptions receivable." The largest asset is $42,000 worth of "unrecovered development
costs." The equity side of the balance sheet is made up of $78,000 of "Common Stock
Subscribed."

The company is contemplating a public offering to raise $1 million. The shares to be sold to the
public for the $ million will represent 40 percent of the then issued and outstanding stock. There
are two officer-employees of the company, Mike Whale and Willie Float, former officers of
Canadian Brass Co. Float is being sued by the SEC for misusing funds raised by Canadian Brass
in a public offering. The funds were used as compensatory balances for loans to a Physics Inc.
Physics Inc. was controlled by Float and is the predecessor for Sunny Energy Applications.

Canadian Brass is being sued by the SEC for reporting improper (exaggerated) income. Float
was chief executive at the time. Many organizations are engaged in researching the feasibility of
using solar energy. Most of the organizations are considerable larger and financially stronger
than Sunny Energy. The company has not been granted any patents that would serve to protect it
from competitors.

REQUIRED
a. What potential risks may be present in this engagement?
The potential risks which may be present in this engagement fall under the category of
special circumstances and unusual risks. This is also a case where there is an
independence issue and possibly conflict of interest because both Whale and Float
are engaged in criminal proceedings with the SEC. I also feel that the integrity of the
management is questionable at best.

b. What specific auditing and accounting problems appear to exist?

The specific auditing and accounting problem I see is that the $42,000 of unrecovered
development costs should not be listed as an asset. In this case, it should be classified
as a loss. Another problem I see is that the stock subscriptions receivable account does
not seem to be appropriately classified. This account is heavily dependent upon
equity financing.

c. What additional information do you feel you need to know about the company?
The first piece of additional information I feel I would need to know about this company
would be about their liabilities. Next I would like to know more about their ability to
perform effective and efficient services. Finally I would definitely need to know
more about the criminal investigation proceeding which they are a part of.

d. Do you believe the engagement should be accepted or rejected? Why?

I do not feel the engagement should be accepted at this time. Because of the criminal
proceedings taking place, the independence issues, the competency issues and the
lack of integrity of the management, I feel there is just way too much risk involved.

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 This audit would be considered extremely high risk and I would have to advise them to
seek legal counsel to straighten their mess out.

7-17 (Communication with predecessor/engagement letter) The audit committee of the board
of directors of Unicorn Corp. asked Tish & Field, CPAs, to audit Unicorn's financial statements
for the year ended December 31, 20X3. Tish & Field explained the need to make an inquiry of
the predecessor auditor and requested permission to do so. Unicorn's management agreed and
authorized the predecessor auditor to respond fully to Tish & Field's inquiries.

After a satisfactory communication with the predecessor auditor, Tish & Field drafted an
engagement letter that was mailed to the audit committee of the board of directors of Unicorn
Corp. The engagement letter clearly set forth arrangements concerning the involvement of the
predecessor auditor and other matters.

REQUIRED
a. What information should Tish & Field have obtained during their inquiry of the predecessor
auditor to acceptance of the engagement?
Tish & Field should have obtained information regarding the integrity of management.
They should also have inquired about any disagreements the predecessor auditor and
management may have had about the accounting and auditing and auditing
procedures. Information about any kind of fraud or criminal activity or problems with
internal controls would also have been useful as well as some kind of
confirmation from the predecessor stating that he understood the reason for the
changes.

b. Describe what other matters Tish & Field would generally have included in the engagement
letter.
Tish and Field should include the following information in the engagement letter:
 Information on the company and the financial statements which are going to be
audited.
 The objective of the audit.
 And kind of standards the auditor will use during the audit process including
those from the Generally Accepted Auditing Standards (GAAS)
 The scope of the audit including the responsibilities of the auditor.
 A disclosure statement that even if a proper audit is done, it still may not detect all
forms of fraud.
 A disclosure statement of the responsibilities of management including their
responsibility to prepare all the financial statements and disclose of internal
control systems of the company.
 A specific list of services provided by the auditor.
 A statement of any and all fees and billing arrangements
 A client confirmation agreement request which management will be asked to sign.
This will include the engagement agreement that outlines terms and conditions.

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